Given how much energy I’ve put into this blog, I’m hoping my readers can help me out a bit. I have been getting suggestions that I really need to finish revising my manuscript. So I decided that to better focus on it, I’d devote my blog to the Great Depression for the next two months. Hopefully this will allow for synergy, as I will work on the manuscript and also post bits of it on the blog to get feedback. I will also set a deadline of April 15 to finish revisions, in the hope that this will overcome the commitment problem (since I have little self-control.) The fear of a public embarrassment for not finishing by this arbitrary deadline should force me to get it done.

Of course you readers will have to sacrifice a bit, as the Great Depression may be much less interesting than our Great Recession. But after mid-April I plan to go back to current events. I will also have to sacrifice a bit, because I much prefer blogging, and my inflated ego may not be able to go long without excessively flattering commentaries like this and this.

Today I will sketch out a very brief summary of my explanation of the Great Depression, and the models I use to evaluate it. This will summarize the first three chapters of the book. I’d like to put the entire manuscript on my blog, but I don’t think the publisher would allow that. But here is what I think I can do, I can probably post the three chapters that cover the early 1930s, as they are merely slightly modified versions of papers already in the public realm, published in the early 1990s. So I will do that over the next few weeks.

So the plan is that you can give me feedback on my basic approach, and then later when I post chapters 4, 5, and 6 of the manuscript, a few comments on those as well. You will notice that the writing style of those chapters (much of which were written in the early 1990s), is far inferior to this blog. I still think the content is pretty good, but unfortunately my later chapters are more convincing in terms of economic analysis. But what can I do, we are stuck with the fact that the earliest parts of the Great Depression are the most difficult to explain. And I can’t very well do my narrative in reverse order, like a Hollywood movie with flashbacks. (Or can I . . . )

Part 1. What caused the Great Depression?

I believe the Great Depression had two primary causes. One cause was deflationary monetary policies during 1929-33, and 1937-38. The other cause was five nominal wage shocks during 1933, 1934, 1936-37, 1938 and 1939. These 5 shocks were caused by New Deal programs, and slowed the recovery. This is why the Great Depression lasted 12 years, ending about the time of Pearl Harbor. I don’t know what ended the Great Depression, and don’t really discuss it in my manuscript, but I suspect it had something to do with the German invasion of France, which led to a military mobilization in the US and elsewhere. This may have directly raised AD, and indirectly increased expected NGDP growth by raising the expected inflation rate. Wars are usually inflationary.

I also think there were many secondary factors that depressed output. During 1929-33 there were at least three important adverse supply shocks; Hoover’s high wage policy, Smoot-Hawley, and the big jump in MTRs during 1932. But without the deflationary monetary policy, the tax hike wouldn’t have happened, the wage policy would have had little effect, and even Smoot-Hawley would have had only a modest effect. And of course after 1933 there were many other New Deal polices that inhibited recovery, but I focus on the 5 wage shocks, as I am convinced that they are far more important than the other policies.

You may have noticed that the two variables I focus on are prices and nominal wages. If you look at a real wage series (manufacturing wages over the WPI) it captures both of these effects. I’d rather use NGDP as an indicator of deflationary policies, but lack monthly NGDP data. But I think the WPI does almost as well, at least during periods where monthly industrial production is moving in the same direction. Thus during 1929-33, and 1937-38, we observe both monthly wholesale prices and monthly industrial production falling sharply. It is a pretty good bet that if we had monthly NGDP, it would also have been falling almost continuously during those periods.

If you invert monthly real wages, and graph it against monthly de-trended industrial production, the correlation is amazing. Indeed I regard it as the single most astounding graph I have ever seen in business cycle theory. Especially since modern theory predicts no correlation at all. But this does not mean that changes in real wages drove changes in IP, nor do I make that claim. Rather I claim that the two components drivers of real wages, deflationary monetary policies and autonomous nominal wage shocks caused by New Deal policies, caused the changes in industrial production. My model is completely ad hoc, and I am proud of that fact. I have a model that fits the Great Depression. I don’t believe there are “timeless Platonic models” that fit all business cycles.

Understanding the GD is like peeling an onion, after you remove one layer of causality there is always another inside. So now we know the proximate cause of the Great Depression; deflation, and wage shocks. But what are the deeper causes of each shock? The wage shocks were simply policy initiatives by FDR, all the complexity is in the deflationary shocks.

Recall that the Great Depression was a global phenomenon. Prices fell almost everywhere. The theory of PPP provides one explanation of the linkage. Thus prices fell even in countries like Canada, which did not see a single bank fail. And of course exchange rates were fixed by the international gold standard.

Part 2. How do we evaluate monetary policy under an international gold standard?

Except in 1933, gold was the medium of account in the US during the interwar years. Thus changes in the price level were identical to the inverse of changes in the value of gold. This isn’t a theory, it is an identity. If the price level fell 20%, then ipso facto the purchasing power of gold rose 25%. Thus to explain why prices fell sharply in the US after 1929, we need to explain why the value of gold rose sharply after 1929. That can’t be so hard! And surprisingly, is really isn’t all that hard. The value of any commodity is determined by supply and demand. The fact that gold equaled money doesn’t change that at all.

The supply of newly mined gold is pretty stable, roughly 2% of the stock of existing gold. So to explain any big change in the price level, we will need to focus on shocks to gold demand. Unfortunately, I didn’t have good data on total gold stocks. Instead, I relied on monetary gold stocks. Actually I could have constructed reasonably accurate estimates for total gold stocks, but I found monetary gold stocks served my purposes just as well. All I had to do was consider changes in the non-monetary demand for gold (hoarding or jewelry) to be factors that affected the supply of monetary gold.

So there are two things that could have caused the great deflationary shock of 1929-33; more private demand for gold, and more central bank demand for gold. Both happened, although central banks seemed by far the biggest culprits. Central banks held gold reserves to back their liabilities, basically the monetary base. I had to take a few short cuts for foreign countries, where I used currency as a proxy for the base. This ratio is called the “gold reserve ratio” and is the ratio of monetary gold stocks to currency or the monetary base. The model starts with this identity:

Price level = (monetary gold supply)/(real monetary gold demand)

P = (monetary gold supply)/[gold reserve ratio*real currency demand]

All three variables on the right side played a role in the Great Deflation. But the supply of monetary gold actually increased over those four years, so in net terms it pushed prices higher. Nevertheless, private gold hoarding reduced world monetary gold stocks at certain key moments in 1931-33, and this played a role in the intensification of the Great Depression. During a depression gold supplies will normally increase even faster than usual, as gold is brought to central banks in response to the increase in the real value of gold. Private gold hoarding in 1931-33 (and 1937-38) due to devaluation fears slowed this process, and worsened the Depression.

Even so, the big problem was central bank gold demand, which soared for two reasons. First, people hoarded lots of cash, especially in the US and France. This was due to low interest rates and fears of bank failures. More gold was required to back up this increase in real cash demand. Even worse, central banks dramatically increased their gold reserve ratios. They essentially hoarded gold. Under the “rules of the game” this wasn’t supposed to occur. As gold flowed into your country you were supposed to increase the currency stock in proportion to the rise in gold stocks. Had this occurred, had central banks played by the rules of the game, it is very likely (though not certain) that the Great Depression would not have occurred. There might have been some deflation in the 1930s, but much milder than what actually occurred.

There was almost no currency hoarding during the first 15 months of the GD. Instead, the initial sharp contraction was triggered by a huge increase in the world gold reserve ratio, which drove prices and output much lower in most countries. The only major exception was France. It had recently devalued its currency and prices had not yet fully risen to reflect PPP. As a result, the onset of the Depression occurred about a year later in France.

Part 3. Beyond ideology

I’m not interested in producing a narrative that fits anyone’s ideological bias. Right-wingers may not like the first half of the book. As I indicated, I think Hoover’s supply-side screw-ups were secondary factors. If NGDP falls in half, you’ve got a major depression on your hands, regardless of trade, tax and wage policies. Look how much trouble we’re having adapting to a 3% fall in NGDP in the 12 months after July 2008.

Left-wingers won’t like the last half of the book, as I attribute the slow recovery to FDR’s high wage policies. But although I have a right wing reputation, FDR comes off far better in the narrative than Hoover. Much of it is devoted to FDR’s dollar devaluation policy, which Keynes correctly called “magnificently right.” In contrast, Hoover did absolutely nothing right. He didn’t intervene where he should have (monetary policy) and the areas he did intervene just made things worse. No single ideology was capable of creating a disaster this big (Just as WWII in Europe was jointly produced by Hitler and Stalin.) The first half of the Depression was a failure of right wing economics, as it was conceived at the time. The second half was a failure of left wing economics, circa 1935. If a single screw-up was capable of creating a Great Depression, we would have had many of them. Instead, this 12 year Depression was three times as long as any other Depression in American history.

The current recession (which was also caused by a failure of both right and left wing ideas) may end up being the second longest, at least if we measure it from the onset to the point where unemployment falls below some reasonable figure like 8%. But at least right-wingers no longer believe in the gold standard, and left wingers no longer support the NIRA. So we won’t have another Great Depression. We are making all the same mistakes, but in much milder forms.

Part 4. Proposed Table on Contents

THE MIDAS CURSE: GOLD, WAGES, AND THEGREAT DEPRESSION

Table of Contents

Preface

Part 1: Gold, Wages, and the Great Depression

Chapter 1: Introduction

Chapter 2: A Model of the Great Depression

Chapter 3: Monetary Policy under a Gold Standard

Part 2: The Great Contraction

Chapter 4: From the Wall Street Crash to the First Banking Panic

Chapter 5: The German Crisis of 1931

Chapter 6: The “Liquidity Trap” of 1932

Part 3: Bold and Persistent Experimentation: Macroeconomic Policy During 1933

My first question: are you modeling the Great Depression in the US only? It was a world-wide phenomenon and I tend to get irritated by American commentary that treats it as just a US phenomenon. (Though I notice there is a chapter apparently on Germany.)

I can see an argument for a major contagion effect, but you would have to show a timing-and-mechanisms story for that.

As someone moderately knowledgeable in Australian economic history, we are a good counterpoint, since we had a very severe downturn, but recovered faster and sooner than the US. Though we do have distinct institutional peculiarities. Our high tariffs, wage arbitration system and huge public debt burden (as governments had borrowed heavily, allegedly for infrastructure development: in part to compensate exporters for the effects of tariffs and arbitration) created a relatively inflexible economy based on government suppression of risk. It also meant that our politics tended to be dominated by the issue of public debt.

Mark me down for a pre-order on your book. History ought not to be taught without a focus on economics. Love it.

Question: how far back do you take the opening narrative of the book? How far back do you believe the true causes of the GD go?

As a history nut I think of lots of small and large historical currents leading up to the GD that certainly could be argued to have played a role, but I am sensitive to the tendency to assume that simply because something happened in a certain way proves that it had to happen as it did, or that one event necessarily caused a successive event. From reading your blog for the last 6-8 months I get the impression that you might be willing to argue that the GD could have been avoided even as late as the 1929 if monetary policy had been handled differently (though perhaps the knowledge and theory were not yet in existence). Maybe I’m thinking too ‘macro’, but I’ll throw 3 out there:

1. Although this I could go far further back in time, the shift from Jacksonian ‘easy money’ to the gold standard following the retirement of the ‘greenbacks’ in the years after the Civil War. Through the 1880s and 1890s the monetary tension builds, typified by the farmer/debtors being squeezed by deflation and industrialization/urbanization, peaking with the populists and William Jennings Bryan in the 1896 & 1900 elections. This ‘tight’ money benefits bankers and industrialists who are largely being repaid in ever more valuable dollars, while the real wealth of farmers and laborers is steadily eroded. The idea of being “Crucified on a Cross of Gold”. Was a crisis inevitable while playing by those rules?

2. The Panic of 1907, the newly created Federal Reserve, and the lack of any effective controls over the exponentially multiplying number of banks in the US. Did the excessive credit creation and leverage irretrievably prime the pump for a plunge?

3. WWI, and the relative prosperity and growth in its aftermath facilitated by the comparitive advantage US industry gained over Europe due to the fact that the war left America’s homeland untouched, while continental Europe’s industrial capacity, demographics, and national cohesiveness (especially in the East) were severely set back. Was this an inevitable crash after a nice, long, decade of flappers living it up while the getting was good? (Eat, drink and be merry, for tomorrow you’ll die!)

I suppose multiple books could be written on each of those questions, and I can’t help but cringe at the generalizations/oversimplifications (not to mention outright omissions) I just made, but I guess the heart of my question is whether you think all of that sort of historical nonsenese is really pertinent to the causes of the GD, or if much of it simply amounts to atmospherics. Obviously it matters to some extent, but if the answer lay in monetary policy all along, then perhaps attributing the GD to large scale historical undercurrents is succumbing to the temptation to view history as an inevitable sequence of events, rather than something more along the lines of a random walk.

Feel free to answer succinctly, I think this question may have gotten a bit broad and/or off topic, but I couldn’t help myself.

I don’t agree about “Smoot-Hawley” having little effect without the bad monetary policy, but the rest sounds good to me. Smoot-hawley was huge and would have had monetary effects as the fallout from the global tarrifs being put, up hurt unit farm banks which then “contagioned” (is that a word) larger banks.

1. Also, you may want to look at de jure increases in gold price and how that affected NGDP falling. During the great depression, the state raised the price of gold fairly arbitrarily. (and sometimes they did it following a real bills doctrine)

2. They also confiscated gold which lead to gold being hidden and thus leaving circulation.

3. Also you may want to look at debt expansion previous to the crash.

4. The Smoot-Hawley tariff and subsequent tariffs being put in place all over the world would account for part of how the problem was global.

5. Also, the US which had at the time produced a sizable fraction of world’s gold began seizing it, which really hurt the supply of gold flowing to other countries.

[…] "http%3A%2F%2Fcheapseatsecon.wordpress.com%2F2010%2F02%2F09%2Fsumner-on-the-great-depression%2F" } Scott Sumner has begun blogging about his manuscript that he has been working on regarding the Great Depression, […]

I would also like to second your point about not going for generic models of downturns. One sometimes sees attempts to develop generic models of revolution: this has always struck me as profoundly silly since revolutions are so very particular in the circumstances in which they happen and in their results. A generic model of downturns in market economies may be a little less silly but not greatly less so. (See my comment above about Australian institutional peculiarities.)

“But at least right-wingers no longer believe in the gold standard, and left wingers no longer support the NIRA.”
Rightwingers believe in the small and strong Fed balance sheet, and leftwingers are trying to increase marginal taxes on labour via healthcare reform.

I am fairly certain a new reading suggestion isn’t what you had in mind, but since you have a chapter on Germany in 1931, I’d highly, highly recommend Adam Tooze’s ‘Wages of Destruction’ on the economics of Depression era and WWII Germany. Their central banks machinations to maintain the appearance of the gold standard is a fascinating read.

BTW, Tooze’s analysis disagrees with your statement that Stalin was necessary for the advent of WWII. Germany’s leaders viewed the war, especially with France as inevitable and rearmed accordingly and the reality of Germany’s relative economic weakness meant that once rearmament started in the UK, France and Britain it would be a relatively short time before they were overwhelmed by superior armaments.

Lorenzo, Yes and know. The book will be much more focused than many readers would hope. I can’t cover the entire Great Depression. My goal is to explain the GD in the US. However, I do cover a lot of international events as they help explain the world-wide deflation from 1929-33 and 1937-38. The other years focus on New Deal policies, which were a more domestic issue.

Sorry to tell you that the word “Australia” does not appear in the manuscript. But it’s not too late . . .

Chad, One of the novel aspects of my book is that I describe causation in several ways. The proximate cause of a crisis is generally when that event impacts the financial markets. Thus in a sense the GD was caused in September-November 1929, when the stock crash occurred, However I also look at deeper causes, and I agree with experts who single out the distortions caused by WWI—particularly the fact that prices after WWI were far too high given the operation of the gold standard. I don’t spend much time on this, but I do give the Austrian view some acknowledgment.

I also think that 90% of the causes of the GD occurred after the Depression began. And since the stock market is a random walk, and since the stock market followed the economy closely throughout virtually all of the Depression, how could the Depression have been anything other than a random walk?

Greg, You said;

“Britain had an unemployment problem already in the mid 20s. Some countries had a big Great Depression. Others almost none at all.

These are patterns to be explained as part of any adequate account of the Great Depression.”

I can’t explain everything. I seem to recall making an offhand comment at some point that Britain had high unemployment during the 1920s for much the same reason Europe had high unemployment during the roaring 90s. My book won’t focus on everything, but rather on those events that were key. Were there any countries on the gold standard that did not suffer a depression during 1931-32?

Doc Merlin, You may end up agreeing with me more than you think. I agree Smoot-Hawley had big effects, but it was the monetary fallout that was key, as you indicate.

Confiscating the gold had little effect. It went from private hoards to government hoards.

I spend lots of time on the role of gold.

Lorenzo, Generic models are ok for some purposes, but they won’t work for the Depression. It must be ad hoc.

123, I also said that right and left wingers are making the same mistakes this time, just in much milder forms. The right wingers still favor excessively tight money, and the left wingers still favored the 40% increase in the minimum wage, and higher MTRs.

Why was Canada’s experience so different, particularly with regard to banking panics?

Did the Dust Bowl have any influence?

Was the stock market bust of 1929 just a sideshow, or was it an independent factor? (The huge bust of October 1987, similar in size to 1929, resulted in emergency Fed easing, and the economy expanded for almost three more years. Does that mean that monetary policy was all that mattered?)

Temin claims that the ultimate cause of the global Great Depression was the gold standard. Returning to the gold standard caused deflationary impulse. Leaving the gold standard allowed inflation.

Short version of the story:
Smoot-Hawley sparks a round of tariff increases worldwide. Tariffs disproportionately hurt exporters – in the U.S. it’s farmers. Farm banks fail because branching laws prevent them from diversifying to deal with a shock like this. From here, the bank failures continue to spread.

Sorry if you addressed this in your post or somewhere else, I’m pressed for time at the moment.

i like the idea of the narrative in reverse order. i’d rather have the climax of the stock market crashing at the end than the beginning. i suppose i could just read the chapters in reverse order, though. try not to have any spoilers at the end.

or maybe you could tell almost the whole story and then toward the end say: but there is just one thing i dont understand. then retrace your steps with a more satisfying explanation.

You write: “My model is completely ad hoc, and I am proud of that fact. I have a model that fits the Great Depression. I don’t believe there are ‘timeless Platonic models’ [I think you mean *more general* models] that fit all business cycles.” But adhockery is nothing to be proud of. A theory that *explains more* is *ipso facto* better. The ability to explain all depressions would be more impressive than the ability to explain just The Great Depression. Really, though, the latter ability couldn’t stand alone: if you can really explain one occurrence, the explanatory structure you are using must also work for other sufficiently similar occurrences.

You also write: “[P]eople hoarded lots of cash, especially in the US and France. This was due to low interest rates and fears of bank failures. More gold was required to back up this increase in real cash demand.” Did the American and French monetary authorities increase the amount of cash in circulation in step with the increased monetary demand? If not, they didn’t need more gold reserves.

It seems to me that the biggest piece of the early story anyway is the fact that the Fed wasn’t playing by the rules of the game. As you say, the central banks were the biggest culprits in hoarding gold; if the Fed had just increased the amount of currency proportional to the amount of gold then monetary policy wouldn’t necessarily have been deflationary at all.

Perhaps a redundant point given that you did address it. I just wonder whether private demand for gold was more a symptom of or response to Fed policy rather than just another component of the demand for gold generally.

You seem to put the biggest part of culprit on central banks. Basically, you claim that if there was a panic, it was among central banks.
This affirmation has two problems:
_if there is a panic among central bankers, why not among standard bankers or entrepreneurs?
_Wasn’t this panic triggered by the panic among the rest of the economy? (this was peace time and neither devaluation nor floating rates were the norm)

Of course, central banks actions seemed to have worsened. But *individually*, had they any other choice if they wanted to stay in the Gold Standard.

Here is my formulation: Gold Standard or the current system makes the economy extremly sensitive to mood, and worse, make mood rationnal.

To use a comparison, I would not say that a shepherd who brings a sheep flock near a cliff is a sheep killer, even if a wolf frightened the sheeps and make them fall.
Most people would say that cliffs have to be avoided and the shepherd have to be fired but they would also say that the wolf is the killer.

According to your own account, which I have just read above, various central banks had already debased their currencies by printing many more notes than they had gold to back when, faced with market skepticism over the value of their notes, they tried to accumulate more gold, driving the price of gold up (and therefore, the price of notes down). Of course this strained the central banks, because their notes:gold exchange rates were theoretically fixed. Whenever theory doesn’t match reality, theory must yield.

With so many unbacked notes in circulation it was impossible for all of the central banks to simultaneously fill their vaults at par (or anything close) except by causing considerable deflation. Coupled with the collapse of the debt-fueled stock-market bubble and so-forth, this hit the banks hard. Individual savers rightly demanded more cash since they couldn’t trust savings banks and to make their own debt payments. More sophisticated investors demanded more cash because they rightly feared the central banks would resolve their gold problems by devaluing their notes.

When gold is money, “private hoarding” is just a pejorative term for what normal people call “savings.” When you write “[P]rivate gold hoarding in 1931-33 (and 1937-38) due to devaluation fears…” you imply that such savings were irrational, but in fact they were eminently rational and events confirmed it. Now, as things played out, all the major currencies got devalued, and many governments applied tyrannical monetary actions (such as Roosevelt’s gold confiscation) so gold savers didn’t preserve as much wealth as they sought to, but criticizing the savers instead of the crooked bankers/politicians seems unworthy.

Your account supports a theory of the GD which you do not put forward: that it was the collapse of a bubble fuelled by unsustainable debt. Governments accomplished some of their borrowing by debasing their currencies, and when they tried to pull back (that is, to reflate their currencies) they found they could not– partly because there was not enough gold, and partly because the depression reduced tax revenues. Much of private demand for loans was filled by quasi-inflation produced by higher monetary velocity (due to low bank reserve ratios and brokerage margin requirements and so-forth). When the music stopped debtors faced the problem that their investments (or in many cases, speculations) had made stiff losses. Unable to pay their debts they defaulted and cascading defaults paralyzed industry.

The currency devaluations of the early Thirties represented government welshing on its debts and helping private borrowers welsh on theirs. I think you can argue that there was no choice and that devaluation cleared the way for eventual recovery. However, in the short and medium run, robbing net savers demoralized everyone and discouraged industrial recovery, since no one wanted to be a lender, governments having made lenders into suckers.

This sounds like a very interesting book, and I look forward to reading it.

As someone who’s not involved in academic economics these days, the last book I read on the subject was Ahamed’s Lords of Finance. Unless something else comes out in the mean time, it’s going to be my context for this book.

1) Why did CB’s hoard gold (drive up the reserve ratio)? Presumably to prevent a “run” on their gold, or a forced abandonment of the gold standard. If this is the case, then why not examine the counterfactual? It amazes me that so few carry out this exercise. What would have happened if Hoover had taken the U.S. off the gold standard in the 1930? And if the rest or the world had followed (as would have been likley)? Its not enough to point out that France did better: this is not really a counterfactual since it was one country devaluing, the benefits of which are obvious. Bernanke wrote in “Essays…” that a global devaluation against gold would have been beneficial to all trading partners, and you probably agree. But he examines it from the standpoint of raising NGDP AFTER a crash. You would argue that Hoover needed to do it BEFORE NGDP crashed. What would have happened to prices then?

2) I realize you can’t research everything, but one key question is, how exactly did the GD differ from earlier Depressions as far as the gold ratio was concerned? If they were not accompanied by a spike in the gold ratio, then what caused them? If they were, then how did they end sooner? The point is “Depressions” were a feature of the 1870-1929 period, so if the GD was different, then why and what implications does this have? I wonder if a key difference was higher leverage: private leverage in the case of the U.S., public leverage in the case of Europe.

I agree with Philo. Ad hoc is bad. If your explanation for the Great Depression can also help explain our current recession, it suggests you are really onto something rather than just curve-fitting in hindsight. Maybe your model doesn’t explain ALL business cycles, but we should hope it can help explain more than just one.

For some pushback on the claim that Stalin bore responsibility for WW2, see Jeffrey Rogers Hummel’s lectures on revisionist history.

A good question is why Hoover didn’t go off the Gold Standard. I believe it was because he was unable to imagine the expansion of Federal government power to change all contracts in the country to remove “Gold Clauses”, as the “Gold Clause Ban” enacted as H.J.R. 192 on June 5, 1933 under FDR.

In a Hoover speech, October 4, 1932, in Des Moines he says:

“Going off the gold standard is no academic matter. By going off that
standard, gold goes to a premium, and the currency dollar becomes
depreciated. In our country, largely as a result of fears generated by
the experience after the Civil War and by the Democratic free-silver
campaign in 1896, our people have long insisted upon writing a large
part of their long-term debtor documents as payable in gold.

A considerable part of farm mortgages, most of our industrial and all
of our Government, most of our State and municipal bonds, and most
other long-term obligations are written as payable in gold…

…But if the United States had been forced off the gold standard, you in this city would have sold your produce for depreciated currency. You would be paid your bank deposits and your insurance policy in currency, but you would have to pay a premium on such of your debts as are written in gold.”

By the way, in that same October 4, 1932 Des Moines speech, Hoover talks about the gold situation. First, he blames devaluing foreign countries from extracting gold from the US:

“The frantic restrictive measures on exchanges which they took and the abandonment of gold standards made it impossible for American citizens to collect billions of the moneys due to us for goods which our citizens had sold abroad, or short-term loans they had made to facilitate commerce. At the same time citizens of those foreign countries demanded payment from our citizens of the moneys due for goods which they had sold to our merchants and for securities they had sold in our country.

Before the end foreign countries drained nearly a billion dollars of gold and a vast amount of other exchange from our coffers.”

This puts Smoot-Hawley in a different light – perhaps besides simple protectionism, it was an attempt to keep gold from “leaking” out of the US?

Then Hoover talks about the Fed gold reserve:

“I have told you of the enormous sums of gold and exchange that were drained from us by foreigners. You will realize also that our citizens who hoard Federal Reserve and our other forms of currency are in effect hoarding gold because under the law we must maintain 40 percent gold reserve behind such currency. Owing to the lack in the Federal Reserve System of the kind of securities required by the law for the additional 60 percent of coverage of the currency, the Reserve System was forced to increase their gold reserve up to 75 percent. Thus with $1,500 million of hoarded currency, there was in effect over $1 billion of gold hoarded by our own citizens.

These drains had at one moment reduced the amount of gold we could spare for current payments to a point where the Secretary of the Treasury informed me that, unless we could put into effect a remedy, we could not hold to the gold standard in the United States for 2 weeks longer because of inability to meet the demands of foreigners and our own citizens for gold…”

fast Growth -> very, very bull stock market and initially high corporate profits -> more and more debt to GDP and higher interest rate spreads, after all interest has to match the gains people are getting investing in stocks -> constantly increasing demand for currency/GDP ratio to face this growing debt

How can you claim that the price level was determined solely by gold? We had fractional reserve banking then as we do now. Ultimately the “gold standard” means little as long as money can be created out of thin air by the banking system.

“he was unable to imagine the expansion of Federal government power to change all contracts in the country to remove “Gold Clauses”

Thank you for sharing that quote. The comparison to the modern predicament would be to alter all existing contracts to strike out inflation indexing. I wonder how that would fly with today’s Supreme Court?

I know that you expect me to ask this, but do you consider the economics and influence of the Chicago Plan of 33? I also give this general warning: I take criticisms of Fisher, Knight, Viner, and Simons, very seriously!

Let me offer an analogy for you – the increased _private_ demand for gold (or indeed, the increase in demand for gold by Central Bank A vs. Central Bank B) can be viewed as a run on the Central Bank (or, alternatively, the currency).

Ahhh.. but that’s absurd one might say, because the value of dollars increased! There was deflation, no? How could a run on the currency be causing deflation?

Yes, but there was deflation _because_ the central banks tightened monetary policy in order to defend their gold reserves! The CB’s placed the value of their currencies as more important than the productive employment of economic resources – it represented the victory over the Populist movement in the latter 19th century.

But seeing that the CB was willing to destroy the economy (and its tax base, and therefore its own solvency in the long run) in order to preserve the short run value of the currency only intensified the run on the Central Bank – which forced the Central Bank to use even more draconian policies (if you think in real interest rate terms) to defend gold.

Remember my arguments that the Fed triggered the mass panic in Sept/Oct 08 when it signalled that it cared more about fighting commodity inflation (which was a manifestation of a carry-trade driven run against the dollar) than supporting the economy? Same dynamic. The parallel between the gold standard and the commitment to keep the dollar as the international reserve currency is quite clear.

Considering how much trade has collapsed this time around, Smoot-Hawley has long been overemphasized, as to the US anyway. It only raised tariffs from 50% to 66%, sizable but not as immense as usually depicted. Other countries responses were more significant.

As far as welching on debts, no one is entitled to unanticipated real returns. With inflation, the indices only have to be tweaked as they have been in the past.

Like several others I’m really interested in why the gold reserve ratio suddenly increased. Are you planning to answer this question in your book? Is it true, as some suggest, that central banks had issued too much paper money during the preceding boom and needed the additional reserves because confidence in paper cash declined? If so, I like StatsGuy’s comparison of this with a bank run – swapping notes for gold, as in a normal run people swap demand deposits for notes.

The other possibility I can see is that the central banks were worried that their gold pegs were going to come under attack for geopolitical reasons of some kind. Given the climate of the times it wouldn’t surprise me, although I can’t see how anyone would actually benefit.

Was the problem the gold standard per se or the hoarding by the CBs? Would a classical gold currency have experienced the same problems? If all the gold flowing into the US had translated into currency would deflation had been such an issue?

Statsguy refers to the Fed’s policy of shedding Treasuries in early 2008. I’ll assume this drove the negative “un-borrowed” reserves in mid 2008. Per Statsguy’s comment wasn’t this similar to the growing “gold reserve ratio” commented on in the 1929-33 time period?

Is there any published rational for the Fed dumping Treasuries in 2008?

“I believe the Great Depression had two primary causes. One cause was deflationary monetary policies during 1929-33, and 1937-38. ”

It is a bad start as far as I am concerned. Why is it that deflationary policies in 1920 did not cause a great depression? If you remember your history, Harding and Mellon cut taxes, reduced government spending by nearly half, and ran surpluses. By 1920 unemployment had gone up from 4 percent to around 12 percent, and Gross National Product had fallen by approximately 17 percent. The Fed did not step in to add liquidity even as debt was being retired or defaulted upon.

A better argument is the one by Hayek, Mises, Rothbard and most economists of the Austrian School. They point out that the crisis is usually caused by easy money policies in the boom period that precedes it. That was certainly true of the mid to late 1920s, when the Fed was expanding the money supply recklessly and by doing so encouraged malinvesments by individuals who misread the preference for savings and assumed that there were sufficient real savings that would allow for the deployment of resources for use in the higher-order stages of production. By mistaking inflation for savings they made bad investments that had to be liquidated during the subsequent contraction. While that would have caused a deep by short recession, meddling by Hoover and FDR turned it into a depression.

A good explanation can be found in the following short but brilliant video.

“But what can I do, we are stuck with the fact that the earliest parts of the Great Depression are the most difficult to explain.”

Of course they are, when you insist on avoiding even looking at the data on what preceeded the Depression, you are willfully making sure it becomes hard for you. The sad reality is that it was the inflationary monetary policy of the 1920’s that caused the stock market crash, the deflation, the secondary deflation, the bank failures and the genesis of the Depression. But you’d have to look at some data to see this, and not even the Hayek-Keynes rap video has convinced you of this.

“I believe the Great Depression had two primary causes. One cause was deflationary monetary policies during 1929-33, and 1937-38. The other cause was five nominal wage shocks”

-So I can deduce that you do not know what caused the 1929 crash, nor do you think that it mattered for the GD. How on earth do you manage to convince yourself of this?

“I don’t know what ended the Great Depression,”
– How about the Robert Higgs view that what ended the GD was the END of the war and the END of the New Deal, the political paralysis from having a Democratic President and Republican Congress and the collapse of government spending. This view implies that everything in the Keynesian worldview is upside down. Which it is.

Part 2: I’m amazed you miss the glaringly obvious and tautologically true explanation: the “price of gold” increased because the money supply increased. When money is backed by gold, and the quantity of money is increased, the exchange rate between gold and money increases. Without monetary manipulation, gold production will not affect prices significantly. All throughout history, the price of gold remains largely constant except when massive monetary manipulation happens. Your looking at hoarding, production and jewelry is missing the point completely.

Thanks OGT, You are probably right about WWII. Regarding German history, I have to draw the line somewhere, otherwise the book will never end.

B.B. The standard view is that Canada benefited from nationwide banking. This has always been my view as well. In the last year I’ve also come to the conclusion that even the diversified Canadian banks are better than our diversified banks. They seem to be managed more conservatively. I’m not sure if that was true back then.

The Dust Bowl seems to have little impact on the data. Things that seem important (like Katrina) often have little macro effect. Demand-side shocks dominate. I focus like a laser on NGDP during 1929-32.

You asked:

“Was the stock market bust of 1929 just a sideshow, or was it an independent factor? (The huge bust of October 1987, similar in size to 1929, resulted in emergency Fed easing, and the economy expanded for almost three more years. Does that mean that monetary policy was all that mattered?)

Temin claims that the ultimate cause of the global Great Depression was the gold standard. Returning to the gold standard caused deflationary impulse. Leaving the gold standard allowed inflation.”

The stock crash is hard to explain, but was partly caused by the same forces that caused the Depression. Yes, a more expansionary policy would have prevented the Depression. We needed a policy of about 1% deflation because of the paucity of new gold. Temin is right, but can’t explain why the Depression occurred when it did, and why it lasted so long. That’s what I try to do.

Matt Simpson. Yes, S-H had negative monetary effects, although the ones I discuss are different from those you mention. I should cite that paper, it sounds good.

Thorfinn, I published it on line, it’s called “TheMoneyIllusion.”

rob, I should tell readers to reread Chapter 4 when they finish the narrative. Like the opening to the Goldberg Variations, it would seem different after everything that came after, hopefully more convincing.

Thanks EconSchill.

Philo, I doubt a single theory could explain all Depressions. Could a single theory explain all bankruptcies?

Philo, They often increased gold holdings even faster than currency rose. Also note that everything on the demand side is in real terms. Both cash and gold demand. So higher real gold demand doesn’t necessarily mean more actual cash in circulation. In 1929-30 it simply meant that the monetary base fell more slowly than the price level.

Adam, Thanks for the post. That’s a good point. The event is very complicated, so we’ll never know for sure. But it is quite possible that if central banks had played by the rules of the game the Great Depression would not have occurred. And private gold hoarding was mostly a response to the Depression itself, so if central bank hoarding had not occurred, neither would private gold hoarding. But these comments should be no means be seen as “exonerating” the gold standard. The proponents of the gold standard at the time rarely criticized central banks for hoarding too much gold. The rules of the game were never formally agreed to. And many gold standard proponents claimed the system could work even if central banks hoarded gold. So the Great Contraction was definitely a failure of right-wing ideology at the time. They controlled the monetary system, and they blew it.

Jean, No, that is not my argument. I use the rules of the game as a benchmark. Any central bank could adhere to the rules, and still stay on the gold standard. They hoarded far more gold than needed. When we left the GS in 1933 we had the world’s largest reserves–way more than we needed. We were like a miser who was slowly starving to death because he was too cheap to spend the cash hoard under his mattress.

Piper, Countries did print too much money in WWI, but by 1929 the problem seemed to be under control. There is no reason why the central banks could no have continued on the same path as 1922-29 for many more years. Maybe not forever, but at least up until WWII. Of course that counterfactual is silly, as WWII never would have happened if central banks hadn’t hoarded so much gold.

You said:

“When gold is money, “private hoarding” is just a pejorative term for what normal people call “savings.” ”

No pejorative was intended. Economists use terms like cash hoarding and gold hoarding in a purely descriptive way, as an increase in real balances.

I don’t accept the view that the 1920s were an inflationary bubble. The economy was in sound shape in mid-1929, and should have been able to continue expanding in the 1930s. There was a slight problem with inadequate gold production, but nothing too serious.

Devaluation did not reduce industrial production in the short run, it led to a sharp increase. Even the devalued dollars received by creditors in 1933 had far more purchasing power than the dollars lent out in 1929; creditors who invested in government bonds did extremely well during the Depression.

Howard, Yes, Mundell’s lecture is very good.

Hillary, Lords of Finance is an outstanding book. His views on the Depression are similar to mine. But his is mostly history, mine is mostly economic analysis.

David Pearson, You said;

“1) Why did CB’s hoard gold (drive up the reserve ratio)? Presumably to prevent a “run” on their gold, or a forced abandonment of the gold standard.”

No, that was not the main problem. The big hoarders (US and France) had far more than they needed. Sure some was needed, but they had plenty in 1929.

You said;

“You would argue that Hoover needed to do it BEFORE NGDP crashed. What would have happened to prices then?”

No, that’s not what I am saying. Hoover could not have devalued in 1929, he would have been put in a lunatic asylum. We needed to refrain from gold hoarding during 1929-30.

You said;

“2) I realize you can’t research everything, but one key question is, how exactly did the GD differ from earlier Depressions as far as the gold ratio was concerned? If they were not accompanied by a spike in the gold ratio, then what caused them? If they were, then how did they end sooner?”

Great question. There was a comparable spike in the gold ratio during 1920-21. The data is messier as many countries were off gold. But the US was in a dominant position after WWI. I think our ratio went up by well over 40%, enough to push the world ratio up by about 17%, ceteris paribis (Warning numbers are from memory.)

Why was 1920-21 milder?

1. All the deflation was compressed into about one year.
2. Wages were more flexible for three reasons
a. Wages had recently soared, and workers knew they were a bit inflated in 1920.
b. We didn’t have Hoover’s high wage policy which leaned on firms not to cut wages.
c. We didn’t have the NIRA, which slowed recovery during the New Deal.

I think the similarities and differences between 1920-21 and the GD strongly supports my interpretation. I haven’t studied the 1890s, but my guess is that private hoarding was more important back then. There was fear that the dollar would be devalued due to silver agitation. The problem in the 1870s was US deflation to get back onto the gold standard, and many other countries adopting gold, which increased demand for gold and pushed up its real value.

saifedean:
“The sad reality is that it was the inflationary monetary policy of the 1920’s that caused the stock market crash”

Inflationary monetary policy? In the four years ending September 1929 price inflation averaged -0.6% per year. What inflation rate should they have been targeting, -3%? Sumner and Friedman are right: the economic growth of the 1920s was not, by and large, unsustainable and the Great Depression wouldn’t have been great at all if the Fed had eased policy enough to prevent a decline in NGDP. By the way, I think Hayek was a great economist and was right about many things -just not this.

Scott,
Will you include a discussion of the 1920-21 Depression in your book and how/why that deflationary episode was different from the early years of the Depression? It’s my understanding that the economy was able to adjust to the lower price level relatively quickly because the deflation followed the inflation surge of 1917-20. So expectations, and therefore nominal wages, were easier to re-anchor at lower levels – they were the levels that had prevailed just a few years before. I could be way off here though.

Wasn’t one of the arguments given by more hawkish members of the Fed during the Depression that the economy bounced back quickly after 1920-21 and was bound to do so again without additional action. A discussion of the key reasons for why that view was mistaken would be interesting.

The Debt/GDP ratio climbed _massively_ from 1929 through 1933, and only started decreasing in 1933, AFTER money loosened. If Debt _alone_ caused the GD by itself, then why did it spike so much after the GD started, and reverse in the middle of the GD – 1933? What’s your causal mechanism?

“How about the Robert Higgs view that what ended the GD was the END of the war and the END of the New Deal”

It seems like the the GD ended in 1939… and 1945-47 brought a heavy post-war collapse which a lot of people thought _could_ have become a depression, but for some very significant interventions – the Marshall Plan, the Cold War, GI Bill, etc. The government’s role in the economy was massively larger in 1947-48, than it was in 1929. So are you simply saying that a _relative_ decrease in govt spending (after the largest wartime expense in history) rescued the economy? Because, you know, tax rates in 1947 were – um – excruciating compared to 1929.

Instead of arguing from authority and dropping names, let’s try looking at some data. Here’s a nice assembly:

Scroll down to the federal receipts/outlays as % of GDP. Look very hard at the 1945 to 1949 period. Note that the increase in federal outlays PRECEDES the increase in federal revenue (taxes). And, consider that an increase in federal outlays in one year means it was _budgeted_ (and expected) even earlier than that.

Note the US debt ratio throughout the period, both overall and federal, and how it aligns with timing of economic phases and with presidential administrations. Not a clean story for the Austrians or the Keynesians, though both sides keep trying to force-fit the data to their theories.

TGGP, Of course there are many similarities between then and now, and I agree that my study would be useless if it didn’t offer lessons for today. But the model must be different. The US price level is no longer determined by the value of gold. If the Chinese hoard dollars, that is not deflationary for the US. In contrast, if the French hoarded gold in 1930, that was deflationary for the US. That is what I meant by ad hoc.

Didn’t Stalin invade Poland in 1939? And isn’t that invasion generally viewed as the beginning of WWII in Europe? I admit that my knowledge of political history is weak, so perhaps I missed something.

Mr. Econotarian, Those are good points. But I think it was more than that. Even if he knew he could invalidate contracts, it is very unlikely Hoover would have left gold. Most investors didn’t even expect FDR to devalue, and he was far more left wing than Hoover.

It is also important to recognize that Hoover was pushing the Fed to adopt more contractionary policies in 1929-30, so he bears part of the blame for the Depression.

Regarding the Des Moines speech, I discuss that quite a bit in my book. The speech was a disaster for Hoover, but I’ll defer that issue until I post chapter 6 in a few weeks. It is a bit rich for him to blame foreigners. The Brits devalued partly due to the tight money in the US, which was favored by Hoover. Smoot-Hawley was probably not an attempt to prevent gold from leaving. It was enacted well before problems with the gold standard developed. In June 1930 no one could have imagined the UK leaving gold.

The last paragraph you quote, what Hoover said was completely inaccurate, and helped cost him the election when it was noticed by the press.

cucaracha, You said;

“Do you want to find the cause of the Great Depression ?

fast Growth -> very, very bull stock market and initially high corporate profits -> more and more debt to GDP and higher interest rate spreads, after all interest has to match the gains people are getting investing in stocks -> constantly increasing demand for currency/GDP ratio to face this growing debt”

This statement is not accurate. If you are referring to the 1920s, it is not true that Currency/GDP rose, it fell. If you are referring to the 1930s it is not true that there was a big increase in private borrowing. The very similar 1987 crash didn’t even cause a tiny ripple, so the 1929 crash could not have caused the Depression.

Income inequality doesn’t cause depressions, otherwise the 1990s would have been followed by a Great Depression.

Noah Yetter, You said;

“How can you claim that the price level was determined solely by gold? We had fractional reserve banking then as we do now. Ultimately the “gold standard” means little as long as money can be created out of thin air by the banking system.”

Fractional reserve banking could affect prices by affecting the demand for gold. Suppose the money multiplier fell because people hoarded cash. That cash had to be backed by gold, so the demand for gold would rise. That would be deflationary. The same story was told be Friedman and Schwartz this way: private hoarding of cash reduced the money multiplier, which reduced M1 and M2, which was deflationary. So we are telling similar stories using different languages.

Don the libertarian Democrat, Sorry, but I don’t look at fiscal policy. A book can’t study everything, and I try to focus on gold policies and wages, which I think explain most of the Depression. Others have looked at fiscal policy. I don’t buy the argument that tight fiscal policy caused the 1937-38 Depression.

Statsguy, You asked:

“Have I convinced you yet of the importance of the carry trades?”

No, but I very much like the rest of your comment. BTW, the closest modern equivalent to the process you describe is Argentina circa 2000. There was a run on the peso, and they had deflation as well.

That is a very interesting paradox that I wrestle with all through the book. I have some ideas, but I am not completely satisfied with them.

Lord, The government also lacked quarterly GDP data, although modern economists have tried to estimate quarterly data. However that data is reconstructed based on the same sort of monthly data that I use.

I agree that tariffs weren’t the main problem, although S-H did a lot of damage, but probably more on the monetary side. It seemed to be deflationary.

I agree with your point about debts.

Simon, You said;

“Like several others I’m really interested in why the gold reserve ratio suddenly increased. Are you planning to answer this question in your book? Is it true, as some suggest, that central banks had issued too much paper money during the preceding boom and needed the additional reserves because confidence in paper cash declined? If so, I like StatsGuy’s comparison of this with a bank run – swapping notes for gold, as in a normal run people swap demand deposits for notes.

The other possibility I can see is that the central banks were worried that their gold pegs were going to come under attack for geopolitical reasons of some kind. Given the climate of the times it wouldn’t surprise me, although I can’t see how anyone would actually benefit.”

No, central banks weren’t forced to increase their gold ratios. The reasons are complex. In the US it was a mixture of tight money to stop the stock boom, and an unintentional increase that flowed from interest rate targeting (yes interest rate targeting caused mischief even back then.) France increased the ratio on purpose. The French simply loved to get lots of gold. They saw it as a sign of economic strength. Partly it was rebuilding gold stocks lost in WWI, but it went way beyond that. In 1931 they lost confidence in paper money when Britain devalued, and that made them want to hoard even more gold. Anyone interested should read Clark Johnson’s book on the subject.

rob, Anyone is free to make a cartoon version of my ideas. People probably already think they are cartoonish.

Keith; You said;

“Was the problem the gold standard per se or the hoarding by the CBs? Would a classical gold currency have experienced the same problems? If all the gold flowing into the US had translated into currency would deflation had been such an issue?”

Yes, but there was no golden age of the gold standard. It was never run as intended. If central banks had enough discipline to run a gold standard in the correct way, and maintain a stable gold/currency ratio, they they would also have enough discipline to make fiat money work. That is the central dilemma of the gold standard.

The equivalent of a higher gold ratio in the 1920s would be a smaller monetary base today. So I think you are right on your second point.

Many have raised the 1920 issue – why didn’t that become the GD? Let me add one more small stone to the pile – margin borrowing.

Conventional asset allocation theory suggests that the more an asset falls the more one should allocate to it. However, emprical data have validated moving average trends (and yes, many hedge funds arbitrage against these trends). BUT, these trends are PROCYCLICAL. That means that arbitraging against these trends actually reinforces them, causing everyone to watching with baited breath to see if a trend turning point is hitting, which is then followed by steep market action.

But, going back to 1929. You might want see if there’s easy data to get on proportion of assets held on margin. The reason is that if an asset falls, margin requirements (and other liquidity constraints) can FORCE selling into weakness, creating a positive feedback loop. I don’t think this is an alternative to a tight money story, it’s just one aspect of that story.

Vangel. The contraction of 1920-21 lasted one year because the deflation lasted one year. The contraction of 1929-33 lasted 3 1/2 years because the deflation lasted 3 1/2 years.

You said;

“A better argument is the one by Hayek, Mises, Rothbard and most economists of the Austrian School. They point out that the crisis is usually caused by easy money policies in the boom period that precedes it. That was certainly true of the mid to late 1920s, when the Fed was expanding the money supply recklessly and by doing so encouraged malinvestments by individuals who misread the preference for savings and assumed that there were sufficient real savings that would allow for the deployment of resources for use in the higher-order stages of production.”

It is important for readers to understand that this argument is completely inaccurate. During this period of time the money supply was regarded as the monetary base, which is the money actually created by central banks. The ideas of M1 and M2 came much later with the work of Friedman and Schwartz. The monetary base was 7.007 billion on January 1925 and 7.075 billion on September 1929. Far from there being a “reckless” increase in the base, it actually grew far more slowly than the economy. And it is also not true that the 1920s were an inflationary decade, prices actually fell during the 1920s. And not just 1921, but also between 1926-29.

The Austrian theory that a reckless rise in the money supply led to an inflationary boom is about as wrong as a theory can be. It is factually wrong, and it also doesn’t at all explain the post-war period, when we really did see inflationary booms in periods like the 1960s.

There is a much more respectable Austrian theory of the Depression. That is the theory that the Fed should have stabilized NGDP in the 1920s.

Saifedean; You said;

“-So I can deduce that you do not know what caused the 1929 crash, nor do you think that it mattered for the GD. How on earth do you manage to convince yourself of this?”

I try to explain why the stock market crash occurred in October 1929. Can the Austrians explain the timing?

You said;

“I’m amazed you miss the glaringly obvious and tautologically true explanation: the “price of gold” increased because the money supply increased. When money is backed by gold, and the quantity of money is increased, the exchange rate between gold and money increases.”

I think you misunderstood my point. I was discussing the period when the exchange rate between money and gold was fixed by the government. (1929-32)

David. Yes, I expect that. They have strong views on the Depression.

Thruth, The first ad was “Suffering from depression? Try our . . . ” Google works off key words, I guess they think my readers suffer from depression.

Thanks Gregor, Your comments are very perceptive. In my first reply I made similar points about wage flexibility in 1921.

Both in 1930, and recently, Fed officials relied on simplistic comparisons like the 1921 example you mentioned.

Statsguy, I mostly agree, although I wouldn’t say the GD ended in 1939. We were still deep in depression in the spring of 1940. Between the invasion of France and Pearl Harbor, industrial production soared. Those were the key 18 months.

In modern times (post WW2), the deep recession of 1973-75 was a consequence of a supply shock (oil) in an already inflationary environment.
The 1980-82 recession was the result of an adaptation to a “regime change”.
The Great Recession of 2007- was the result of mistakes that mimic features of the GD. You say: “We are making the same mistakes but in much milder form”. But what´s relly perplexing is that it shouldn´t be happening. After all, the “Maitre D” today is the foremost academic specialist on the previous disaster (which has turned in one of economics biggest laboratories) and we know that he knows that he managed to botch things.
In his tombstone, one day, we´re likely to read: “Here lies the man who didn´t practice his sermons when given the chance to do so”.

So by virtue of the 1921 “Depression” having the same plausible cause — gold hoarding — but shorter length, wouldn’t that suggest that the gold standard caused the GD, but not its duration?

If you step back, you can see that the benefits of “convertibility” (the gold standard) are spread over time. Those benefits are, essentially, lower real term interest rates and higher risk-adjusted returns on long term projects. Additionally, the stability caused by the gold standard resulted in a higher ratio of world trade than would otherwise be seen. The cost of “saving” convertibility, on the other hand, is very lumpy: to “save” it involves hoarding gold, and thus sending a signal to speculators that a run will not be successful. Hoarding gold led to Depressions during that period. So its easy to say the gold standard “causes” depressions.

Was the benefit of the gold standard less than the cost? We don’t know. I don’t even think that’s the question. The real question is, “can we know if the benefit was less than the cost.” Sorry to cast doubts on the value of your research, but I believe we cannot, in fact, “know” this. We can make arguments informed by data, but those arguments, in the face of a nest of impossible-to-prove counterfactuals, are less than conclusive.

We can only do two things in the face of imperfect knowledge: experiment or act as prudently as possible. Experimentation works when the tail risks of failure are acceptable. When they are not, prudence is warranted. Are you sure that the tail risks of NGDP targeting are both well understood and manageable? Certainly the vast majority of economists thought that the tail risk of Greenspan’s asymmetric monetary policy was, in fact, negligible, and arguably they spent very little time examining it.

I have one simple question for Austrians, and i ask this as explanation, not as confrontation – which interest rate is set artificially low during boom busts? i hear the argument of a reckless Fed unleashing money supply on an unsuspecting populus, which leads to rates falling, malinvestment, and so on. i am even sympathetic to the Fed making mistakes, they do. but, i never hear the Austrian narrative explain which interest rates of importance are affected the most? during the most recent crisis its mortgage rates. during the depression, it was prob some other rate that caused a cluster of investment error. so under current circumstances, if i were an investor, which rate is artificially low? i want to sell that one…

BTW, Scott, the thought occurs to me, given the Greek situation, that any rules-based system is open to speculative attack, be it the gold standard, the Euro, Argentine convertibility, Bretton Woods, etc.

So, have you thought about how speculators would attack an NGDP targeting regime? Because its not whether, its how.

When the gold standard is attacked, speculators assume prices will RISE once the standard is abandoned. The particular price at issue is the gold price. So the Central Bank responds by hoarding gold, which in either causes the speculators to win (once the Central Bank capitulates) or lose big (as prices crash).

What about an NGDP targeting regime? If speculators assume that the regime will be abandoned, they will buy commodities or NGDP futures. NGDP expectations (more N than R of course) would rise, and the Fed would have to tighten. Tightening would crash NGDP, or it would be so politically unpalatable as to cause the Central Bank to abandon the target, which of course would cause prices to rise and speculators to win big.

What’s the difference? In NGDP targeting, you ASSUME that NGDP expectations cannot rise without RGDP expectations also rising. With the gold standard, speculators’ NGDP expectations can rise (otherwise why would they attempt to hoard gold?) while RGDP is falling. So from my vantage point, if you make a going-in assumption that the “N” and “R” are directly correlated, then of course it will look good. I just hope the speculators make that same assumption.

Scott
Another parallel between now (GR) and then (GD) is the “financial scandals” that prop up. We are told that the backbone of financial regulation enacted in the aftermath of GD was undone beginning around 1980.
Is this sort of thing a driver of the crises or more a consequence of macro management mistakes. The link below is to the Pecora Report that investigated the shenanigans of the 1920´s.http://en.wikipedia.org/wiki/Pecora_Commission

I second the endorsement of Adam Tooze’s The Wages of Destruction, which I review here. The issue of the role of Stalin in the beginning of WWII is covered in the book. I summarise it as: With the defection of Stalin from the ranks of Hitler’s enemies—made possible by the Franco-British guarantee to Poland, which essentially meant the Western Allies were throwing themselves in front of the Soviet Union—there was, to Hitler’s mind, no economic or technological advantage to waiting. So on to war …

I just listened to podcast from George Mason Economics and Liberty in which an economist interviewed made strong case that Smoot Hawley and the international response was a huge factor and led to the crash of the stock market and many bank failures. he breaks discussion down from the big aggregates, and it sounds very convincing on the basis of the timeline. he admits a lot more research on his line of inquiry needs to be done.

‘Didn’t Stalin invade Poland in 1939? And isn’t that invasion generally viewed as the beginning of WWII in Europe?’

I feel guilty contributing distractions to a guy trying to finish a book, but Stephen Koch’s ‘Double Lives….’ makes a strong case that Stalin and Hitler were secretly collaborating as early as 1933. That the Reichstag fire and subsequent trial of communists served both dictator’s ends in allowing them to wipe out domestic opposition.

Yes. A gold standard requires everyone to follow it and behave appropriately. When someone doesn’t, everyone suffers. It isn’t just a matter of speculators but of mistakes as well. The gold standard certainly didn’t prevent the GD. Why would speculators hold gold other than inflationary fears? Deflationary fears, in particular your bank going bankrupt and you losing everything.

In particular there are circumstances that make the gold standard impossible to follow. The most common cause of gold suspension was war. It is possible to return to it afterwards with an appropriate devaluation, France did it after WWI, but it is strongly resisted, as the UK after WWI. The UK suffered through the 20s as a result.

Statsguy, Other researchers have looked at market inefficiencies during 1929. I’m afraid the project is already so sprawling that I wouldn’t be able to add much more. My book doesn’t really take a position on the issue of whether the 1929 crash was completely consistent with the EMH, or just partially consistent.

Marcus, Yes, that’s a great irony. Slightly off topic, but in 1920 if you asked someone like Keynes or FDR “who would be best able to manage a crisis on the Oval Office”, the choice might well have been Hoover, who did a superb job in helping Europe after WWI. Keynes said he was the only one to come out of Versailles with his reputation enhanced, and FDR once said there was no one more qualified to be President.

David Pearson;

You asked:

“So by virtue of the 1921 “Depression” having the same plausible cause — gold hoarding — but shorter length, wouldn’t that suggest that the gold standard caused the GD, but not its duration?”

Yes and no. The gold standard can explain the length of the Great Contraction (3 1/2 years) but not the Great Depression (12 years) New Deal policies caused the Depression to drag on. Even the contraction was longer than 1920-21. Partly this is because the deflation took place over a much longer period of time, and partly (the RGDP part to be specific) it was due to nominal wages being much stickier in 1929-33.

I am more sympathetic to your comments on the gold standard than you might suspect. I don’t favor the system, and think critics like Fisher and Keynes were correct. But at the time the gold standard might have been a big improvement over anything that was a realistic alternative, and in addition our recent problems have convinced me that we aren’t as good at managing fiat money as we would have hoped.

On the other hand, if I were a conservative financier in 1929, and I could look into a crystal ball and see the future, this is what I would have said to myself.

“I used to favor gold, but I can see that in the long run it is on the way out. And fiat money can be managed better than I thought. We might as well abandon gold now, and avoid the Great Depression and all its associated left wing policy reactions. If we are eventually going to target inflation at 2%, let’s start now.”

But of course they didn’t have a crystal ball, and given what they knew at the time, the gold standard seemed the safer bet. Fiat money was poorly managed in the 1970s, in the 1930s it might have been even more poorly managed. But in retrospect it was worth a try.

David#2, You said;

“What about an NGDP targeting regime? If speculators assume that the regime will be abandoned, they will buy commodities or NGDP futures. NGDP expectations (more N than R of course) would rise, and the Fed would have to tighten. Tightening would crash NGDP, or it would be so politically unpalatable as to cause the Central Bank to abandon the target, which of course would cause prices to rise and speculators to win big.”

The Greek crisis is not a speculative attack on the euro, it is an attack on Greek bonds. That could happen under NGDP targeting as well. My plan certainly doesn’t prevent reckless fiscal policy.

Marcus, Despite the Pecora report, banks were far more soundly managed in the 1920s than today. Most of the big banks survived a 50% fall in NGDP. I wonder whether ANY big banks could survive that today. I think even Goldman Sachs would go belly up if NGDP fell in half.

I know Krugman blames deregulation for our problems, but I don’t see any evidence. The deregulation was partly a reaction to the fact that the New Deal regulation nearly drove our banking system into bankruptcy in the late 1970s and early 1980s.

Lorenzo, Doesn’t that support what I just said, that the war started when Stalin allied himself with Hitler? Perhaps you could better explain that point, as I’m still not getting it.

Blades, It did lead to a stock market crash in June 1930. I don’t think the direct effects were very important (as a supply shock) but it had an indirect effect on monetary conditions that was important.

Patrick, Thanks for the info. I know little about this issue, and won’t be able to read anything until I finish the book. But other commenters might also be interested.

As an aside, I wasn’t suggesting that Hitler and Stalin were equally at fault for WWII. Hitler was the more aggressive of the two.

You said: “I try to explain why the stock market crash occurred in October 1929. Can the Austrians explain the timing?”

–I’m not an Austrian; I just play one on internet blogs. So I’ll take a whack at this.

The Austrian (I presume Hayekian as well as Rothabrdian) explanation is that the crash happened after the Fed stopped monetary growth in 1928. This is entirely in sync with how Austrian Business Cycle Theory views crashes, and also, I believe, with your Monetarist-ish take on thing. The difference is that you and Friedman would view the stopping of monetary growth in 1928 as itself the cause. The Austrians would view the expansion of the 1920s as the real cause, whereas stopping the expansion is merely the trigger.

In the Austrian view: you should not increase the money supply at all. If you do, then you have “caught the tiger by the tail” and this will not end well. The only question, then, is when the inevitable crash will happen. If you stop monetary growth early on, then you will get a mild crash and recession. If it goes on for long, you’ll get a giant crash and recession. So, for various reasons (Benjamin Strong’s health, domestic politics, the Brits, etc…) the Fed stopped inflating in 1928. The die was cast, the crash and recession was around the corner. Mises and Hayek spent the 1920’s telling this to anyone who’d listen. But people were more interested in listening to the eugenicist crank Irving Fisher.

If the Fed had continued the monetary expansion, if it had followed a Sumnerian recipe and continued to target high NGDP growth, it would have succeeded in keeping the boom going—but only for a while. At some point, the inevitable result is a collapse: either the dynamics of fractional reserve banking would cause a banking collapse that monetary authorities can’t stem, or the great increases in credit would generate surprise runaway inflation a la Weimar.

Mises’ point is that as long as credit continues to increase at an increasing rate, the fake boom can be sustained. As soon as credit expansion stops or slows down, the whole house of cards comes stumbling down. Get it?

The analogy I like to draw, again, is with that of a crack addict. If you stop giving him crack, then that’s going to cause him a terrible collapse in health and awful withdrawal symptoms. Drs. Sumner and Friedman would “correctly” diagnose the cause of this collapse as the stopping of crack, and would therefore recommend that the patient be returned to his original dose of crack. Dr Hayek, on the other hand, would point out that the crack addiction is the real problem, and the stopping of crack was the harvesting of the problems that the addiction had sown. More crack would not solve the problem, but make it worse. The only end result of an ever-increasing crack habit is death by overdose (hyperinflation).

Is this clear now? Do you see the similarity and difference between your view and the Austrian view? You agree on the fact that the Fed stopping the monetary growth was the “cause” of the crisis. The difference is that they view the expansion itself as being the real cause, while you continue to refuse to ever confront the FACT that the money supply increased in the 1920’s.

Again, I repeat my questions to you: how do you explain the 1929 stock market crash? How do you see its relation to the GD? And what do you think is the importance of the monetary expansion of the 1920s?

On gold price, you said: “I think you misunderstood my point. I was discussing the period when the exchange rate between money and gold was fixed by the government. (1929-32)”

–No, I think you missed my point. “Gold price” at that time was indeed fixed by the government. But as the government increased the money supply, what happened? People started wanting to convert their money into the gold backing it. This isn’t because of a gold shortage—this is because of an increase in paper money. The inevitable and historically recurrent result of monetary expansion under a gold standard (or a gold exchange standard) is a run on the currency. Quite simply: why would anyone want to hold the paper when you know it is being inflated quickly and will lose value, when you are legally entitled to hold the gold backing it that is not being inflated and will not lose value. As soon as enough people realize this, everyone runs to the central bank for their gold and the currency collapses.

This is why I think the gold standard is a terrible idea, and why I disagree with Austrians on their insistence on it. It will always end badly.

So according to my explanation, one would expect a run on the dollar in 1933, 1934. But why did no such a thing happen: because the government outlawed the owning of gold, confiscated it from people and banned people from exchanging their money for gold. Now, the question for you is: if my story is incorrect, why did the government have to do what it did?

You said: “Inflationary monetary policy? In the four years ending September 1929 price inflation averaged -0.6% per year. What inflation rate should they have been targeting, -3%?”

-For the millionth time: you can have a rise or drop in the price level along with inflationary monetary policy. Increasing the money supply has an inflationary effect on prices. Increasing economic growth has a deflationary effect on price. If you combine economic growth (deflationary) with increased money supply (inflationary) the net result can be a relatively constant price level, a rising price level, or a dropping price level. It all depends on the magnitudes of the economic growth and monetary expansion.

Hence, in the 1920’s, you had very high economic growth along with inflationary monetary policy. (Check out Friedman and Schwartz, the money supply increased a lot.) The net result was very low inflation, and slight deflation over the years. This doesn’t mean that there was no inflationary monetary policy. It means that if there was no inflation, then the price level would have dropped even further. We could’ve had -2, -3, -4% inflation every year. This is decidedly a GOOD thing. In spite of all the Keynesian inflationary propaganda, deflation is a good thing. When things become cheaper, you can buy more things, eat more, get a nicer house and live better. This is how economic growth works. The massive deflation in the computer industry over the past 20 years has not been devastating to you, me, or the computer industry. Highly inflationary monetary policy destroys deflation, creates price inflation, and most importantly: causes economic miscoordination which is the root cause of ALL business cycles.

And of course, like Friedman, Schwartz and Sumner, your insistence that the Great Depression would not have been great without the Fed’s contractionary policy misses the important question: where did the depression and crash come from in the first place? So long as you cannot answer that question, you need to think and read more.

Statsguy,

I’m not sure what your point is. I didn’t claim it was debt that caused the GD. I claimed it was the increase in the money supply during the 1920’s, followed by the Keyensian and protectionist policies of Hoover and FDR which made things much, much worse.

If you believe the Keyensian story that the GD ended in 1939, then you basically believe that devoting a significant chunk of wealth and human capital towards the destruction of Europe increases the general well-being of Americans. War and destruction is not a good with any value. Producing bombs and dead Germans does NOT increase the life quality of Americans—it only increases the meaningless Keynesian measures of wealth and economic activity. And that’s the reason these measures are meaningless. You could triple America’s GDP tomorrow if everyone was put in work camps producing only bombs and the government decreed that each bomb was worth $10m. Does that mean Americans are three times wealthier and better-off? I don’t think so. The meaningless statistics bandied about by Keynesians which claim that recovery started in 1939 are all built on this shoddy fallacy: increases in government-produced meaningless aggregates represent real economic improvement.

The important point is that the government’s role from 1946 onwards was massively smaller than it was during WWII and the dark years of the New Deal. This caused an improvement in the economic situation. Yes, in 1946, government was larger than it was in 1929, but you’re missing the important point that it isn’t just absolutes that matter, but mostly, relative changes in government size. In 1929, the government had only ruined the money supply and monetary policy, causing the crash. As the role of the government grew in the 1930’s, the economy suffered more and more. As WWII started, the economy suffered more and more. As WWII ended the economy started recovering, because the albatross of government was being eased—not removed, just eased. But not for too long. The Keynesians were back and by the 1970’s they gave us the wonderful stagflation their scientific models assured us was impossible.

We disagree on speculative attacks. You are presuming the outcome. Any attack on a rules-based regime has two possible outcomes, and by definition, speculators view the probability distributions (winning or losing big) as asymmetrical to “winning” (otherwise they would be speculating!). So it seems like you are presuming a distribution (asymmetrical to “losing” a priori, but not stating your reasons. Is it that the Fed has “deep pockets”? I could imagine that influencing your thinking. I think if you ask George Soros — who took down the pound and the European Monetary System — he would say that everyone told him the BOE also had “deep pockets”. He might say that the deepness of a Central Bank’s pockets depends, ultimately, on their willingness to tighten and cause a recession. Therefore your a priori assumption implies either that 1) the Fed will be willing to defend NGDP targeting at the cost of a recession; or 2) they will never have to make that choice. I’m afraid that if you are assuming the latter, that is a very dangerous assumption.

I suggest putting yourself in Stiglitz’s place, and imagining that the speculator is attacking an NGDP regime. What would you say to him? IMO, Stiglitz doesn’t stand a chance against this guy. You may put that down to misguided Kenynsianism, but I put it down to wanting to believe so badly that he ignores reality.

An interesting question. Do you think ngdp targeting could prevent all recessions, or only monetarily induced ones? I still think real shocks like the oil crises could still induce ones that the economy has to adjust to, but that it would ease this adjustment.

Scott,
David’s video is very entertaining. But this speculator (Hugh Hendry) is actually a fan of your blog and he was betting interest rates will go down when NGDP expectations started falling in 2008 and made a good profit. Hugh Hendry is an example of people who would make NGPD futures market function well.

saifedean – You said: “For the millionth time: you can have a rise or drop in the price level along with inflationary monetary policy. Increasing the money supply has an inflationary effect on prices. Increasing economic growth has a deflationary effect on price. If you combine economic growth (deflationary) with increased money supply (inflationary) the net result can be a relatively constant price level, a rising price level, or a dropping price level. It all depends on the magnitudes of the economic growth and monetary expansion.”

Sure. In theory you can have fall real prices combined with expansionary monetary policy. Its not very likely, but its possible. More importantly, though, the monetary based did no grow during the 1920s – as Scott pointed out above, the 1920s equivalent of M0 rose by a whopping 1% between 1925 and 1929. Watch that expansionary policy go! Is your argument that some other measure of the money supply was growing out of control? If so, which one?

Regarding deflation being a good thing – surely its only a good thing if the prices of things you buy fall. If the prices of the things you sell fall, that’s a bad thing. Since every transaction is purchase for someone and a sale for someone else, the net effect of the price level on welfare is a wash. “Falling prices are a good thing” isn’t a serious argument for deflation, its just propaganda. Its true if an only if you expect to live on savings for the rest of your life. Productivity is a good thing, but it doesn’t actually have to show up in the price level to be a good thing.

I agree that deflation would probably be better. I like George Selgin’s argument for a productivity price level norm, but this is much closer to Scott’s argument for NGDP targetting than it is to the pop Austrian “deflation means I can buy more computers with my giant pile of gold, so more deflation is better”. The key is that the price level should be predictable, so that people can enter into long term contracts. Deflation in a world where inflation is expected is bad for firms and for debtors. Inflation in a world where deflation is expected is bad for savers and those on fixed incomes. The only happy medium is a predictable price level. Scott’s NGDP targetting is the most realistic proposal I’ve seen to get to that form where we are right now.

Scott, I think you and Peter Temin are correct that the gold standard was badly mismanaged, and that mismanagement was a major cause of the Depression and all that followed.
What really bugs me is that no one listened to Irving Fisher, who was acknowledged even then to be America’s foremost economist. His compensated dollar scheme could cope with foreign and/or domestic gold hoarding, and would have been a huge improvement over what actually happened.
Hmmm, everyone, even economists, ignoring the teachings of standard monetary economics. Sounds kinda familiar, don’t it?

Scott, yes I was agreeing with you in general about the role of Stalin, just pointing out that it was not his invasion of Poland that was crucial, but the preceding deal with Hitler which itself was made doable by the Western Allies essentially putting themselves between Hitler and Stalin thus giving Stalin more leverage.

I would also like to endorse Patrick Sullivan’s recommendation of Koch’s Double Lives as a very good book (I review it here), though not one you need to read at the moment. It does show that Hitler and Stalin kept the possibility of a deal with the other open from the moment Hitler became Reichs Chancellor.

saifedean, I can’t remember where I read this, so unfortunately I can’t link to it. But apparently, the size/duration of busts is not at all correlated with that of the prior boom. Rather, booms are correlated with the prior bust! That’s actually part of the reason for the “unit root hypothesis”, but that would be going off field. If Austrians claim that a boom featuring an expanding money supply will always inevitably end in a bust, would that still be correct if it took a thousand years to occur and the “bust” was tiny? This is like the argument about bubbles earlier. If price goes down many years after someone predicted, and even at the trough the price level is still higher than when they called “bubble”, are they vindicated?

You said: “Is your argument that some other measure of the money supply was growing out of control? If so, which one?”

Yes, of course! The monetary measure that matters is the TOTAL money supply. This is beyond obvious. What matters to prices, inflation and deflation would be the quantity of money in the economy, and there is absolutely no reason why the base money matters and the rest doesn’t. I think everyone from Keynesians to Austrians to monetarists would agree with this. This is accounting, not economics!

If you look at the total money supply over the 1920’s, you will find that it expanded from $45.30b to $73.26b in the period you mentioned—a 61.8% increase. So, if economic activity were constant and the economy didn’t grow at all, you would’ve had pretty significant price rises. With economic growth, you could have lower price rises since that means that more money is being offset by more goods. With very high economic growth you might even have deflation.

Is this really so hard to understand?

“Regarding deflation being a good thing – surely its only a good thing if the prices of things you buy fall.”

You’re totally missing the point here. It’s a “good” thing because it is simply the embodiment of productivity increases. If you think more productivity is a good thing, then that necessarily means that you think prices falling are a good thing. You can’t have productivity increases without falling prices—unless you have inflationary monetary policy that negates the price drops by redistributing the purchasing power increases to the recipients of the new money.

You seem to be mistaking my argument for me calling for the central bank to have an explicitly deflationary monetary policy. I am saying that absent ANY monetary policy, the price level will fall because of deflation.

Of course I agree with you that “the price level should be predictable, so that people can enter into long term contracts.” But the point is that without centralized monetary planning the price level would be steadily, predictably and slowly dropping. Any centralized monetary planning would simply be creating monetary distortions by messing with the normal functioning of the price level. That’s the whole point of Hayek’s life’s work: centralized monetary manipulation is necessarily distortionary, like any form of central planning. It will inevitably lead to dislocations, distortions, booms, busts, bubbles and crashes.

TGGP,

“If Austrians claim that a boom featuring an expanding money supply will always inevitably end in a bust, would that still be correct if it took a thousand years to occur and the “bust” was tiny?”

-Well, if pigs could fly, would we be able to use them to replace airplanes? I don’t know, dude; pigs can’t fly. Your question is irrelevant because we’ve never really seen an artificial inflationary boom go on for a thousand years and end with a tiny bust. They always only last a few years, and always end with an awful bust that causes more losses than all the gains of the boom years. ALWAYS.

“The Austrian (I presume Hayekian as well as Rothabrdian) explanation is that the crash happened after the Fed stopped monetary growth in 1928. This is entirely in sync with how Austrian Business Cycle Theory views crashes, and also, I believe, with your Monetarist-ish take on thing. The difference is that you and Friedman would view the stopping of monetary growth in 1928 as itself the cause. The Austrians would view the expansion of the 1920s as the real cause, whereas stopping the expansion is merely the trigger.”

That’s the same view Friedman takes. The problem is that if that were the case, the crash should have happened in 1928, not October 1929. And I do not claim that tight money in the US in 1928 caused the crash, just the opposite.

You said;

“But people were more interested in listening to the eugenicist crank Irving Fisher.

If the Fed had continued the monetary expansion, if it had followed a Sumnerian recipe and continued to target high NGDP growth,”

Fisher is one of the 3 greatest macroeconomists of the 20th century. The Fed was targeting something close to NGDP under Strong, but contrary to your assertion, the growth rate in NGDP was as low as in any other expansion in the past 100 years. There was no “high” growth. It is interesting that in the other post you criticize me for talking about Austrian economics without studying it. I find many Austrian readers have all sort of views on NGDP in the 1920s, or the rate of money growth that are completely false. They seem willing to talk about the causes of the Depression without actually looking at any of the data. There was virtually no increase in the type of money actually produced by the Fed (the base) between January 1925 and September 1929.

In addition, there was no inflation in 1929-32, the paper money was not losing value, and that is not why there was gold hoarding.

cucaracha, You said;

“I meant “demand for currency/GDP ratio”, ie, the ratio of demand for currency (not the stock of currency) to GDP (or to the money stock itself)”

Even so, you’d still be wrong. The real demand for currency divided by real GDP fell significantly in the 1920s.

Debt did rise (as in any expansion) but the Fed doesn’t control debt.

David Pearson. The Soros example actually supports my point. Developed countries usually don’t devalue because they run out of money, they devalue for macroeconomic reasons. Soros won because he correctly predicted that the Brits didn’t want to let NGDP fall. If you are targeting the actual goal variable of policy, the thing the central bank wants to stabilize, then you don’t have that problem of conflicting goals. Currency pegs don’t work because in the long run it isn’t currency that countries care about, it is NGDP or some other macro aggregate. So to avoid speculative attacks, you should target the thing you really care about, so that you don’t have to abandon your target to meet some other goal.

On your second point, the Greece issue isn’t monetary at all, it is fiscal. I would never deny that countries with reckless fiscal policy can get into trouble. But that has no implications for NGDP targeting. Greece is in trouble precisely because the EU let NGDP fall.

Lord, Real shocks could still produce recessions, but only every 50 years or so. Most real shocks are much too small. For instance the 2008 oil shock, by itself, would not have produced a recession in the US if NGDP kept growing 5%. I think the 1974 oil shock might have been barely big enough for a small recession.

123, Thanks. I didn’t know Hendry read my blog.

Simon, Those are good points.

Jeff, Fisher was a great economist, but his monetary policy ideas were too radical for Hoover. FDR did adopt them in 1933, however, so perhaps there is still hope for me.

Lorenzo, OK, now I see your point. Thanks for the book tip.

TGGP, Good point.

Saifedean, That money data are meaningless, as it includes lots of debt. In the 1920s nobody had ever even heard of M2, or “monetary aggregates.” Money was the monetary base, the stuff actually produced by the Fed. It would be ironic if Austrians tried to save their theory by relying on post war concepts developed by Milton Friedman. Governor Strong had never read Friedman and Schwartz, so how was he supposed to target M2?

“The Fed was targeting something close to NGDP under Strong, but contrary to your assertion, the growth rate in NGDP was as low as in any other expansion in the past 100 years. There was no “high” growth. It is interesting that in the other post you criticize me for talking about Austrian economics without studying it. I find many Austrian readers have all sort of views on NGDP in the 1920s, or the rate of money growth that are completely false. They seem willing to talk about the causes of the Depression without actually looking at any of the data. There was virtually no increase in the type of money actually produced by the Fed (the base) between January 1925 and September 1929. ”

We keep going back to this point:

You refuse to acknowledge that the TOTAL money supply in the 1920’s matters towards price inflation, deflation, the business cycle. You’ve used all sorts of arguments, none of which make any sense.

The bottom line is that the money supply that matters to the economy is not the base, but the total money supply. If the base stays constant but the money supply doubles, you’d get price inflation. If the base doubles but the money supply stays constant, you wouldn’t get price inflation (or perhaps only a bit from increased velocity, possibly).

The Austrian theory, which you still do not seem to understand at all, looks at changes in the TOTAL MONEY SUPPLY, and NOT the monetary base as significant for starting the business cycles. This is just how the theory is, and this is plain common sense. It would be completely retarded to attempt to argue that what matters to price inflation and business cycles is the monetary base and NOT the total money supply. It doesn’t matter one bit what Fisher and Strong thought they were targeting. It doesn’t matter one bit when the measure of money supply was invented. The monetary base matters only to the extent that it affects the total money supply. What matters to the starting of the business cycle in the 1920’s was the total money supply. This is what the Austrian theory would predict; and this is what the data confirms.

You seem to be suggesting that since M2 measure wasn’t around in 1929, then the total money supply couldn’t have mattered. So since the metric system wasn’t around 10,000 years ago, does that mean that a rock falling on you would cause you no pain since it is weightless?

When John Law, the father of modern macroeconomics started the Mississippi bubble that destroyed the French economy, the measures of the money supply were not invented as well. And yet, it was the increase in the money supply that caused that crazy bubble, just like the 1920’s, 1907, 1873, 1893 2008, and every other boom-bust in history.

You refuse to contemplate this, and insist on continuing to be ignorant about the causes of the crash. Dogmatism has its charm. Best of luck.

Also, MB that matters but the ratio of MB to the total money supply (MB/MZM or MB/M3) is also important.
If the MB/MZM ratio gets too small it leads to “brittleness” in the financial sector. Because most forms of money don’t automatically re-price themselves quite like MB money does.

In addition to that, the ratio of MB to total debt and MB to total public debt is also very important. It can show brittleness in the entire economy.

“Even so, you’d still be wrong. The real demand for currency divided by real GDP fell significantly in the 1920s.”

Oh semantics…

If you mean “money under the mattress” you are right – if you don’t consider 1930 and later – but what really matters here is an initially high money velocity (from narrow money to m2) making stock prices, profits to skyrocket.

However, as you know, this also makes debt to skyrocket – think about margin borrowing to take advantage of a bullish DJIA, for instance – almost in the same proportion and often even more than stock prices and profits (and income). This debt growth also allows a GDP growth from increased consumption even though the majority of consumers – not investors – see their real income fall in proportion to real GDP.

And now you have a surging interest and principal that has to be paid. And now you have people and businesses needing to save more – a decreasing money velocity – to make sure they will able to pay their debts.

And – because of this decreased money velocity – the profits fall, making stock prices plunge with them. And with the profits and stock prices plunging the debtors capacity to pay their debts also plunges. And with the debtors capacity to pay their debts plunging the quality of the banking system assets also runs dramatically lower.

And some banks start to crash and others start to gather narrow money, increasing the interbank rate spread – which means an increased demand for currency, ie., for narrow money – which sends more banks crashing and more people putting money under the mattress, which sends even more banks to bankruptcy.

“Debt did rise (as in any expansion) but the Fed doesn’t control debt.”

I don’t know if the reserve requirements might be managed by the FED the same way they might today. If so, the FED could at least have imposed a limit on banking leverage long before the crash – which would help to control debt growth.

saifedean – What is the “total money supply”? The monetary base is the supply of stuff you can actually exchange for goods and services – for the 1920s, that means federal reserve notes, gold, and some combination of reserves and demand deposits. Isn’t it clearer just to treat everything else as debt? What’s the utility of treating things you need to convert into money in order to spend as if they were money?

There’s no question that there was a huge increase in credit during the 1920s. But there was a huge increase in the sales of lots of other things too – cars, shares in general electric, art. During booms people buy and sell more things. Including credit. The velocity of circulation goes up. That’s what a boom is. So all the “total money supply” tells you is that people bought and sold more credit. But they bought and sold more cars too. We don’t include cars in the money supply – why include credit that’s not interchangeable with base money?

If you look at it this way, its much clearer that the Austrian argument is missing evidence. Where is the evidence that the expansion and contraction of credit drove the boom and subsequent bust rather than merely being part of it?

Rothbard makes a big deal of bank reserves increasing during this period, but the monetary base as a whole grew much more slowly than real GDP, as confirmed by the drop in the price level. So this isn’t evidence of inflationary policy – quite the reverse. The money supply grew more slowly than real GDP and the price level dropped. The only alternative explanation was that the price decline was due to across the board productivity improvements, but where is the evidence for this?

Maybe we should check out if interest rate spreads went higher right before the 1929 crash.

I think about a lot of securitized debt being sold at the same time to generate cash to invest in stocks and an enormous demand for credit based on greater consumer and investor confidence -> thus making interest soar and the DJIA plunge right after as a consequence.

This might have made the fall in corporate profits irrelevant to the crash itself although one could forecast that those profits would inevitably diminish with a higher interest and debt to gdp ratio.

@saifedean’s: you make an interesting point about total money supply and the fact that it wasn’t measured doesn’t make it irrelevant. Of course, there’s still the fact that there wasn’t any inflation and to explain the depression as a commensurate reaction to a failure of letting prices contract by 3% a year seems hard to believe. Plus Austrians can’t explain the lack of a similar depression following the 60s and 70s inflations. What’s your explanation for the severity of the GD in contrast to the recessions of the late 60s and 70s? Especially since most of the latter can be easily understood as oil supply shocks.

saifedean, Hayek was around in 1929, how did he define “the money supply?” Even if you are right, it means the interwar Austrians were just as clueless as the Fed.

It’s not the Fed’s job to control M2, they control the monetary base.

You said:

“Dogmatism has its charm”

I agree with you there. That’s why my book won’t be liked by any dogmatists, as I criticize all schools of thought.

Thanks Patrick.

Doc, What is brittleness?

cucaracha, You are making a lot of errors, mostly mixing up money and credit, which are completely unrelated concepts.

Simon, Yes, you are right. There were no unusual increases in even the broader aggregates during the 1920s. My hunch is that even the broader money supply grew at a slower rate than during most postwar decades. There is no way anyone can argue the 1920s were particularly inflationary, they simply weren’t. M1 went from 23 billion to 26 billion. Big deal. That’s roughly population growth. The Austrians will never get anywhere asserting money was highly expansionary in the 1920s.

Central banks can do open market sales, or raise the discount rate. This will tend to cause gold to flow into their coffers. At the aggregate level it is harder to see, as the gold ratio may go up not because there is more aggregate gold, but because the monetary base falls.

Travis #2, it’s even worse. The 1927-29 expansion was the ONLY expansion during the 20th century to feature deflation. That’s got to be pretty embarrassing for those who say “If only we’d had deflation in the 1920s we would have avoided the Depression.”

“Recession begins in August, two months before the stock market crash. During this two month period, production will decline at an annual rate of 20 percent, wholesale prices at 7.5 percent, and personal income at 5 percent”

That’s it… High leverage, gold standard, high income inequality – which was offset until the consumer debt leverage could not go further -, the Fed raising rates.

All contributing to a crash that was clearly predictable two months before.

I think your reply is simply an attempt at obfuscating away what money is in order to render the Austrian theory mute. I don’t buy it. Fortunately, I’m fresh from teaching intro to macro and can remember all the details. The problem with all your argument is that credit is money and not a good. Cars are goods and not money.

I like to take the definition of the money supply to be the total money and the money substitutes. And I take money substitutes to be what can be converted at par into money at any time on demand.

A car is not money, it is a good. Its value changes based on its condition, supply, demand and much more. There is nothing in a car that guarantees you conversion into a set amount of money at any particular time. A bank deposit account, however, is money. It is expressed in terms of money, has no purpose or use beyond being a claim on actual money. It can at will be converted into money. If you triple the quantity of cars in an economy, there will be no price inflation and no increase in the money supply. There will be deflation as cars become cheaper. If you triple the quantity of deposit accounts, you will get an increase in the money supply and, eventually, price inflation.

Once you clarify this confusion, you can see the problem with the rest of your argument.

“Where is the evidence that the expansion and contraction of credit drove the boom and subsequent bust rather than merely being part of it?”

–The increase in goods is economic growth. The increase in credit and money is monetary expansion. The two are independent phenomena that don’t need to take part together. If you have a constant money supply, you can have economic growth with more cars, art and toys. If you have monetary expansion, you might not have growth in actual production of stuff.

So, the problem with the 1920’s, and the reason that the Austrian explanation has a lot going for it, is that the increase in money was directly caused by the Fed. It did not increase the monetary base, but we all know that they don’t need to increase that to increase the total money supply.

It was the Fed that was openly and by its own admission engaging in open market operations with the stated purpose of stopping the drain of gold from Europe. They bought sterling, shipped gold to France and Germany, lowered the interest rate, increased bank reserves and, in the immortal words of Strong, gave “a little coup de whiskey to the stock market.” This all increased the money supply. All of this is thoroughly detailed in Rothbard’s America’s Great Depression.

Now what if the Fed did absolutely none of these things, and the money supply remained constant? I know this is hard to imagine because of the elastic nature of money under fractional reserve banking, but assume so for the sake of argument. What would happen is that the economic growth would’ve continued throughout the 1920’s, giving us more cars and art and toys, while prices dropped. If this were the case there would have NOT been a crash in 1929. This means that the monetary expansion of the 1920’s is a sufficient and necessary condition for the emergence of a bubble and bust.

“Rothbard makes a big deal of bank reserves increasing during this period, but the monetary base as a whole grew much more slowly than real GDP, as confirmed by the drop in the price level. So this isn’t evidence of inflationary policy – quite the reverse. The money supply grew more slowly than real GDP and the price level dropped. The only alternative explanation was that the price decline was due to across the board productivity improvements, but where is the evidence for this?”

–This paragraph is a complete mess and I don’t know where to begin with it. For the love of all that is holy, it isn’t the monetary base that matters for price inflation, but the TOTAL MONEY SUPPLY. Common sense! Any increase in the money supply is inflationary. If the money supply grows by as much as GDP, that is still inflationary monetary policy. If the money supply grows LESS than GDP, but still grows, that’s also inflationary.

The relatively constant price level was a function of increasing productivity. In spite of all the monetary mischief of Fisher and Strong, there was a real strong economy that produced cars and countless other inventions that made Americans’ lives much better. In fact, part of the story of why the bubble happened in the stock market was the ridiculous and retarded attempt by Irving Fisher to “scientifically manage” the price level of different goods, while allowing Americans to benefit from the wealth effect of a booming stock market. While goods’ prices were dropping thanks to productivity increases, Fisher was urging more inflation to keep prices constant! And as the government was giving a “coup de whiskey” to the stock market and the stocks boomed, Fisher mistook this for a real wealth effect stemming from the genius of his scientific monetary management! This is the 1920’s equivalent of Barney Frank deciding to “roll the dice on subsidized housing”. This is why our esteemed Fisher made the worst predictions in all the history of macro (just think of the competition!) when it came to the stock market. His whole worldview and actions were built on the idea that the stock market will continue to boom. That it didn’t was not just a tragedy but a thorough and comprehensive destruction of Fisher’s views on economics and money. And it was supreme vindication for Mises and Hayek who spent the 1920’s arguing in vain that the inflationary boom was sowing the seeds of disaster.

And yet, till today, people view Fisher as a genius and refuse to ever consider reading anything by Hayek, or heaven forfend, Mises!

I’ve addressed your point on price inflation on this thread and the previous one and will not repeat this point.

“Plus Austrians can’t explain the lack of a similar depression following the 60s and 70s inflations. What’s your explanation for the severity of the GD in contrast to the recessions of the late 60s and 70s? Especially since most of the latter can be easily understood as oil supply shocks.”

Easy: the GD was severe because of Hoover and FDR’s statist, protectionist and price-fixing policies, as well as the Fed letting the money supply collapse. The postwar depressions were less severe because we’ve not had Hoover and FDR’s policies, and because the Fed has not let the money supply collapse—but that, in turn, only led to more recessions down the line.

How about if I told you I agreed with the monetarist explanation for how the depression became Great, and also agree with the Austrian explanation of the stock market crash and the original causes of the depression? What exactly is so hard to understand about this simple point?

The Austrians possess the only coherent, non-laughable explanation for what caused the 1929 crash. The Austrians of the time predicted it, anticipated it and were vindicated. That’s a very important point which no one can doubt, and all the attempts at alternative explanations are as lacking as this one by Scott.

Now, in my opinion, what explains the severity of the depression, and how the crash went from a crash to giant 17-year global disaster, is a combination of the statist, protectionist and price-fixing policies of the Hoover and FDR administrations, as well as the monetarist story of allowing the money supply to shrink—with a caveat.

After the stock market burst, and banks started collapsing, the money supply started shrinking. Friedman and Schwartz, Sumner and Bernanke are all correct in pointing out that if the Fed had prevented the money supply from collapsing through liquidity injections, increasing reserve, lowering interest rates, etc… then the collapse would not have been as bad. But…

This ignores the vitally important Austrian story of the causes of the original crash. Once you understand the Austrian story (and believe me, you easily can!) you will realize that reinjecting all the liquidity into the economy might prevent a giant collapse, but will only lead to a bigger collapse later down the line, along with giant price inflation.

Which is why the only recommendation worth being made by an economist is for there not to be any increase in the money supply in the first place. Once you’ve started on the road of increasing the money supply, you’re just going from one disaster to another, each one becoming bigger and more destructive.

Which brings me nicely to the post-war era. The US Government has not had any hang-ups on carrying out enormously inflationary policies during this period. The status of the dollar as the global reserve currency, and the fact that it was the currency of international trade meant that inflationary American policies would not just have inflationary and boom-bust impacts at home, but all over the world.

So, every time the US has inflated, the resulting bust would be met with more inflation. So, the reason we have not had a depression as big as the Great Depression is twofold:
1- The money supply was not allowed to collapse after every bust, since the Fed was being far more Sumnerian in the postwar era than under the GD (in no small thanks to the severing of all ties with gold, and the dollar as a global reserve currency)
2- We thankfully never saw a President run retarded protectionist and price-fixing policies as awful as those of Hoover and FDR (although we might, soon!)

But… this does not change the fact that we have had countless recessions in the postwar periods. Can anyone explain the causes of all these recessions? All the Keynesian explanations of them are, well, nonsense. The 1970’s stagflation was not an “oil shock”, the “oil shock” was itself a result of the inflationary monetary policies of the world’s reserve currency. Remember, after the large inflations of the 1960’s (Viet Nam and the Great Society) the US had to close the gold exchange window in 1971. What replaced that? An agreement with OPEC to “back” the dollar with oil. As the inflation of the dollar supply continued, oil prices went through the roof. The 1973 six-day-war may have been the trigger of this, but the real reason was the foolish attempt to back the dollar with oil while continuing to inflate merrily.

All these cycles of boom and bust were clearly preceded by monetary expansion, in a manner that completely fits the Austrian story. The biggest depression came in 1982 when Volcker had enough with Sumnerianism and decided to protect the dollar from collapse by stopping the printing presses. As both Sumner and the Austrians would predict, this led to a giant recession. But, as Sumner would conveniently forget, this was followed by a swift recovery, similar to that of 1920, the Depression you’ve never heard of. You’ve never heard of it because the government doing nothing meant that the economy recovered quickly.

Now, remember, for the millionth time, nothing in the Austrian story tells you that monetary expansion will lead to a crisis as bad as the GD—just that it’ll cause a boom, bust and recession. From then on, it depends a lot on the government how bad things get. Letting the money supply collapse will be painful, but could bring about a quick recovery (just as in 1920 and 1981). Reflating would cause the crash to be less painful, but cause inflation down the line, and another bigger crash further on (1970’s, 1992, 2001, and, soon we’ll see, 2008.)

I think I understand your argument pretty clearly: if the Fed doesn’t fix money supply at X amount and allow prices to deflate, then we are doomed to some sort of big bust.

It just seems implausible to me that the difference between 4% deflation and whatever deflation that we had between 1927 and 1929 is a sufficient explanation for the steepness of the initial downturn, before Hoover and FDR got their hands on the economy.

Also, are you saying that the crash of 2008 is a result of our policies in the 1970s? We’ve just had too many inflations without the ‘bigger crash’ for the Austrian story to be plausible.

As for Austrians predicting the depression, well Austrians have predicted *every* downturn. It just takes them sometimes 10 years to be right. Remember Hayek in the 60s. He said he was just surprised at how long it took for the downturn to occur. I too can predict every downturn given those standards.

I first thought you meant I was in fact taking money as credit and vice versa.

By the way: money and credit are different concepts – in this sense one could say that they are “unrelated” – but there is an obvious correlation between money attributes – supply, velocity, multiplier, etc – and the supply of credit.

If “mix up” means to correlate the money and credit supplies then I will have to stick with this error.

“I think I understand your argument pretty clearly: if the Fed doesn’t fix money supply at X amount and allow prices to deflate, then we are doomed to some sort of big bust.”

I wouldn’t say we’re doomed for a big bust. I would just say that any increase of the money supply is, by its nature, a distortion of the pricing mechanism of the economy and will lead to dislocations, distortions, bubbles and busts. That’s the gist of Hayek’s work. The reason it seems to blasphemous to mainstream economists is that they cannot get themselves to ever contemplate that:
1- There is never a need for anyone to manage the money supply. Any quantity of money is enough and the economy could grow at any rate with a fixed money supply.
2- Increasing the money supply is always and forever a bad thing on net for the economy as a whole.
3- For the price mechanism to work in an economy, it needs to be free of monetary distortions. An elastic money supply will inevitable cause distortions
4- Therefore, the central bank managing the money supply is the cause of, not solution to, economic problems.

“It just seems implausible to me that the difference between 4% deflation and whatever deflation that we had between 1927 and 1929 is a sufficient explanation for the steepness of the initial downturn”

-Think of how big the increase in the money supply was over the 1920’s. But more importantly, you need to realize the pernicious and destructive dynamic of the business cycle and the bubble that these monetary manipulations cause. Even a small increase in the money supply will cause a bubble, necessarily. This is because as the extra fake money is pumped, it must go into a specific sector of the economy at a rate higher than other sectors. This leads to prices, returns and profits increasing in that sector more than fundamentals suggest. The dynamic of the bubble is set in motion. Everyone wants to invest in this sector, but then when the bust happens, you realize that these investments were unproductive because they produced something for which there was no real increased demand. The really awful thing about it is that all the resources, capital and labor that went into the bubble are foregone from other uses. That’s the real disaster and why these bubbles are so destructive.

Just think of the recent housing bubble, and how much labor and capital went to build worthless homes which nobody wants now. Imagine how much better off everyone would be if these resources went towards producing something that people actually want.

This is a huge problem with Sumner’s treatment of this financial crisis. Somehow he thinks that the distortion of the production patterns within the economy is not such a big deal, and would not have big impacts alone. Worse, he refuses to acknowledge that this distortion was itself caused by monetary expansion in the first place, and somehow thinks that more monetary expansion would avert the worst impacts of this crisis.

This is what happens when economists start believing that the largely meaningless, abstract and theoretical constructs they develop to get tenure in college (GDP, AD, AS, inflation) have a serious causal and effective impact on the world and can be managed and controlled to affect one another like a hydraulic system.

For Sumner: economic growth and reduction in unemployment means increase in NGDP. Therefore, increasing NGDP means economic growth and reduction in unemployment, and if only the Fed would increase NGDP enough, then everything will fall into place. He doesn’t consider that these meaningless statistical and theoretical relations don’t actually hold in the real world. He cannot contemplate the role of prices in coordinating production, and the massive distortionary impact of messing with the money supply in which prices are denominated.

“Also, are you saying that the crash of 2008 is a result of our policies in the 1970s?”

-Not really, but that the moentary expansion was the cause of this crash as well as the previous ones. When you think of this clearly, you can see that the 1970’s third world debt crisis was the giant global bubble that American monetary central planning brought the world. Mexico, Brazil and Turkey were the Lehman, Goldman and Morgan of the 1970’s. As the Fed expanded the money supply, the World Bank directed tons of cash to these developing countries towards unsustainable development projects, creating an unsustainable bubble that collapsed when Volcker raised rates.

“As for Austrians predicting the depression, well Austrians have predicted *every* downturn. It just takes them sometimes 10 years to be right.”

–This is true. Some Austrians seem to be always predicting doom, and whenever anything bad happens, they claim vindication. But you should remember that Austrians generally do not believe in the ability to predict anything which is caused by human action. I like Hayek’s take on prediction in economics, where he says in matters like this it is not really possible to make precise predictions about magnitudes, dates and precise details, though pattern predictions are possible. So, whereas in the 1960’s, the ruling Keynesian establishment was patting itself on the back for having eliminated business cycles (some things never change) Hayek and the Austrians were certain the monetary manipulation of the Fed had not eliminated these business cycles, but will instead make them worse and bigger when they arrive. They couldn’t tell you when and how they would happen, but they were right that they would arrive and be worse than before.

cucaracha, If it was so obvious, why didn’t investors see it? The stuff you mention was also true at various points during 1928, but there was no crash in 1928.

Saifedean, I disagree that there was a bubble in the 1920s in the sense that resources were diverted to wasteful uses to a high degree. Obviously any economy has some waste. But the growth in the 1920s was much more sensible than our subprime fiasco. It was entirely appropriate that labor was allocated to building more houses, factories, cars, appliances, office building, etc. Those assets are valuable to society. It only seems like we built too much because we allowed demand to collapse.

I also don’t agree with your view that postponing a slump in 1930 would have led to an even bigger slump later. The US economy has grown in real terms at 3% a year for over 100 years. Let’s take the worse case and assume there were some misallocation problems in the 1920s than needed to be squeezed out of the economy. Suppose the Fed had allowed just enough NGDP growth after 1929 for RGDP to grow 2% a year, rather than 3%, over the next decade. In that case we would gradually be able to work out the excesses by operating at slightly less than full employment, as labor was gradually re-allocated to other uses, but no big slump was required. Remember, we could average 3% real growth indefinitely—so if the economy overheated and grew a bit too fast, it merely needed to grow a bit lower than average to get on track. BTW, I think our trend rate may be below 3% in this century.

The Austrians seem to be claiming that recessions are caused by visible policy errors that occur before the recession begins. They also seem to be claiming that if we followed their policy advice we could have less severe recessions. Those beliefs are implied predictions, whether they like it or not. Nobody else will take them seriously until they can explain why the worst depression in modern history was preceded by the LEAST inflationary business expansion in modern history. Maybe that’s unfair, but that’s how the rest of the world looks at Austrian economics. It doesn’t seem to fit the facts.

All of our disagreements stem from the fact that you are, whether you like it or not, an unreconstructed Keynesian. You may differ in your policy conclusions from the hardcore Keynesians like DeLong and Krugman, but you all share the same analytic way of looking at economics, which is so wonderfully exemplified by this sentence: “It only seems like we built too much because we allowed demand to collapse.”

No. “demand” collapsed because so much money was invested in worthless bubbles that produced fake returns that made people think they were far richer than they actually are. This, in turn, caused them to spend much more and save much less than they otherwise would have. When the bubble burst, they had to cut down on spending and start saving as any sane person would do when they realize they had been living beyond their means because their wealth was nothing but a Fisherite money illusion. This is what you Keynesians call “demand collapse”. It is NOT the cause of the downturn; it is merely the result of the wasteful spending and investment which was the result of Fisher’s attempts at “scientific price management”.

You cannot continue to pretend not to get this point, and instead cling to the nonsensical Keyensian notion that the root causal factor governing everything in the economy is the nominal amount of spending. There is no physical law in the universe that physically, causally and reliably ties spent dollars with employment and national wealth. It would be wonderful if such a thing existed, and a politician who discovers such a thing would surely win an election with this promise. And any economist who promises a politician such an idea will be named the “master” and have his ideas propagated for decades even after they continuously, repeatedly, inevitably fail in all their outcomes and predictions in every single episode.

“Nobody else will take them seriously until they can explain why the worst depression in modern history was preceded by the LEAST inflationary business expansion in modern history.”

Two glaring mistakes in this:

1- the 1920’s was not the least inflationary period. Look at the TOTAL money supply; compare it to other periods. Monetary policy was very inflationary. You cannot deny this by pretending the monetary base matters and not the total money supply.

2- And if you read what I wrote above you will realize that I accept your (and Friedman’s, and Bernanke’s) interpretation that what made the depression so much worse was the Fed “allowing the money supply to contract”, along with the awful price-controls and protectionist measures (though we differ drastically on implications). Let’s all agree that those are what turned a crash into the greatest depression in human history. Fine? But, you cannot simply be happy with that and ignore what caused the depression in the first place! Friedman and Schwartz’s Monetary History remarkably almost skips the entire 1920’s and doesn’t mention them at all in its discussion of the GD. You have also exhibited such a remarkable blind spot for anything happening in the 1920’s, and continue to insist on avoiding seeing what happened to the TOTAL money supply during that period. The only way your monetarist story can be held together is by completely wishing away the 1920’s. But the 1920’s happened, and they can’t be wished away. And if you witness a 61.8% increase in the money supply, you have to admit that the Austrian explanation makes sense. You can still cling to your explanations of why the crash became such a giant depression, but it is no longer tenable to believe the inflationist take on the 1920’s being all honky-dory, and that the inflationary boom could’ve been maintained indefinitely with sufficiently expansionary monetary policy.

“In that case we would gradually be able to work out the excesses by operating at slightly less than full employment, as labor was gradually re-allocated to other uses, but no big slump was required.”

This is another glaring example of why you are a true Keynesian hydraulic economist. You cannot social engineer labor reallocation and expect it to work itself out gradually thanks to your centrally-planned increases in NGDP. Continuing to inflate in a burst bubble will only lead to a magnifying the distortions that led to the crash in the first place. Bailing out homeowners, mortgage providers, construction firms and MBS-making I-banks will not rid you of the housing bubble, it will only exacerbate the bubble, make it last longer and grow bigger. These bail-outs will keep your beloved NGDP high, but they will not fix the fact that millions of people and billions of dollars have gone towards building houses that no one wants. In fact, it will only succeed in directing MORE workers and dollars at building MORE houses no one needs.

To paraphrase Hayek: Your aggregates, Mr. Sumner, like those of Mr. Keynes before you, conceal the most fundamental mechanisms of change.

I strongly suggest you read Hayek’s Nobel Prize acceptance speech for some really thought-provoking ideas on the Keynesian aggregation disorder.

And I encourage you then to consider the completely crazy alternative hypothesis to your Keynesian worldview: it isn’t the movements in centrally-planned aggregates that determine what happens to individuals, firms and industries; it is rather what happens on a micro level that shapes those aggregates, and attempts at centrally-planning aggregates will inevitably have the impacts that any form of central planning has: distortions and waste which will be reflected on a micro level with individuals, firms and industries.

saifedean, For someone who has contempt for economic aggregates, you certainly seem fond of aggregates like M2. As I already noted, the money supply showed little change in the 1920s, whether you define it as the base (as I do) or M1, as most economists do. I you want to claim M2 is the money supply that’s fine. But M2 is an aggregate that includes actual money created by the Fed, and all sorts of credit created by the commercial banking system. Surely the Austrians are not arguing the Fed should be worried about controlling an aggregate like M2? That’s about as un-Austrian a view as I can imagine. So why even mention the 61% jump in M2? It has no relevance for monetary policy.

You said;

“1- the 1920’s was not the least inflationary period. Look at the TOTAL money supply; compare it to other periods. Monetary policy was very inflationary. You cannot deny this by pretending the monetary base matters and not the total money supply.”

This is another problem many Austrian commenters have, they use their own private language. Inflation is a rise in the price level, not a rise in the money supply. You may not like that definition, but that’s the accepted definition. If you want to communicate with other economists, you’d better use the same language or else they won’t know what you are talking about. The business expansion of 1927-29 was the only expansion in the past 100 years that was deflationary.

You said;

“This is another glaring example of why you are a true Keynesian hydraulic economist. You cannot social engineer labor reallocation and expect it to work itself out gradually thanks to your centrally-planned increases in NGDP. Continuing to inflate in a burst bubble will only lead to a magnifying the distortions that led to the crash in the first place.”

Here again, you must not have read what I wrote, as I was discussing a deflationary monetary policy. BTW, I am about the least “hydraulic Keynesian” economist on the planet. Recall that I think the fiscal multiplier is zero—not exactly hydraulic Keynesianism.

“Surely the Austrians are not arguing the Fed should be worried about controlling an aggregate like M2?”

–Dude, the Austrians’ whole worldview rests on the impossibility of “controlling” the money supply and on the fact that all economic crises come from the misguided foolish attempts at doing so! M2 is useful as a measure of money supply. No measure of money should be controlled by any centralized authority! Is that distinction too hard to grasp?

“This is another problem many Austrian commenters have, they use their own private language. Inflation is a rise in the price level, not a rise in the money supply.”

-So what? Change the terminology whichever way you like, the point still holds! The Fed (which controls the money supply) presided over an increase in the money supply. Call banananization if you like, the fact still fits perfectly with Austrian theory.

“Recall that I think the fiscal multiplier is zero—not exactly hydraulic Keynesianism.”

–That’s still hydraulic Keynesianism! The point I made was in reference to your belief that targetting a meaningless aggregate like NGDP could have magical impacts on the economy by fixing misallocations and preventing depressions! That, in terms of hydraulics, is up there with Keynes, Fisher and the best of them.

saifedean – The following seem impossible to rectify: The supply of base money didn’t grow significantly in the 1920s, the “total money supply” created by the private banking system did grow, the fed partially controlled only the supply of base money, and yet the increase in the “total money supply” was the fault of the fed. I must be missing something somewhere – where?

The “total money supply” doesn’t really seem to be a useful concept. You haven’t offered a definition, but you quoted numbers that are from Rothbard’s “America’s Great Depression”, and he defines the total money supply as everything supposedly redeemable at face value for base money. But this leads him to include not only long-term time deposits and term shares, but even life insurance policies.

This isn’t M2, its not even M3. Its like M3+. Fair enough if its useful, but is it? Austrians should presumably be skeptical of the validity of adding the value of life insurance policies to the stock of gold and assuming the resulting number means something. The money supply matters because it constrains the nominal value of transactions that can take place at any given time – if the volume of transactions goes up, either the price level has to fall, or the money supply has to expand. But given this, why include time deposits and life insurance policies? They don’t play a role in the possible nominal value of transactions because they have to be redeemed for actual money which is then spent. The constraining factor is the smaller supply of actual money.

The only possible role for these very illiquid assets in the money supply is to lead people to think they have more wealth than they would believe if they could accurately assess the possibility of the financial institution defaulting, so they spend actual money they would have saved. But this is just a variant of the wealth effect. If you consider it a reason to include these things in the money supply, why not include shares in general electric? Or houses? Their prices also affect the demand to hold money, and they equally can’t all be sold at once without affecting their value, so why not?

Note that I’m not arguing that credit bubbles aren’t an important factor in recessions – they might be, I have neither the expertise not the historical knowledge to judge, but I find Scott’s viewpoint at least as plausible. There certainly were credit crunches associated with both the 2008 and 1930 contractions, and those contractions were certainly relatively severe compared with those immediately before them. But this doesn’t prove causation – it could also be that dramatic economic contractions cause credit to contract along with everything else.

I am arguing that by showing that the supply of debt increased during a boom in the face of an almost-constant supply of base money, you haven’t proven anything. Of course the amount of debt increased – nominal GDP was rising fast and the amount of base money was essentially constant, so the velocity of money had to increase somehow, and debt is the easiest way to move money to where its needed. To actually support the Austrian theory you’d need to show that the fed actually had effective control over the supply of credit (eg. by showing that the supply of base money and the supply of credit were correlated) (I doubt it did, or does), and that there was an oversupply of credit (eg. by showing that real interest rates fell).

Simon, I also have no idea what point saifedean is trying to make. He says the Fed has no business trying to control M2, then he says money was increased greatly, even though the MB hardly budged. So he doesn’t want the Fed to control M2, but blames them for it rising, even though it reflects the decsions of private actors in the economy, not the Fed. I have no idea what all that means. Perhaps if there are any other Austrian readers they can expalin, because I must be missing something.

I’m just one of those hydraulic Keynesians, like Hayek, who want the Fed to target NGDP. So I am too dense to understand all of this subtle Austrian economics.

Scott – I went and read part of Rothbard’s “America’s Great Depression” to try to figure out what saifedean is talking about, since I suspect its the Rothbard/Mises view of the depression that saifedean is really trying to defend (since Hayek didn’t really have a view to defend, or rather he had several at different times).

Rothbard doesn’t directly give numbers for the monetary base, but he does talk a lot about reserves and the “total money supply” (ie. credit) – from his numbers is looks like reserves grew quite substantially during the 1920s, and gold and cash in circulation actually fell a little. Although reserves were only a small component of the base, the argument seems to be that they were effectively higher powered than cash, and therefore responsible for the large increase in private credit.

But Rothbard holds the Fed responsible not because it failed to control the level of credit or even the level of reserves (he’d probably agree that that’s impossible) but rather blames the very existence of the Fed and its reserve accounts for the expansion in credit.

If you take the baseline as being 100% reserve, gold-backed banking where there is no credit money at all (which Mises and presumably Rothbard would have favored), or even free banking where banks would need to hold more reserves because there’s be no discount window to resort to, it certainly is true that the Fed allows more credit to be created. Still doesn’t prove that credit creation was responsible for the crash, though.

I was away for a few days and dropped this thread, and I’m still amazed at how you continue to pretend not to get what I’m saying. I’m going to simplify:

1- The total money supply is what matters for inflation and business cycles, not the monetary base.

2- The total money supply and the monetary base do not have to move in the same direction. You can have an increase in the base along with a decrease in the total money supply (witness 2008). Or an increase in the total money supply and a decrease in the base (witness the 1920’s). This should be obvious to Scott, of all people, who insists that the doubling of the base in 2008 was contractionary.

3- In a system of fractional banking with a lender of last resort, i.e. centralized command control of the banking system, the central bank controls the monetary base and the total money supply, however incompetently.

4- In the 1920’s, the increase in TMS was caused by the Fed. I will elaborate and simplify this point: During WWI, all the belligerents engaged in inflationary monetary policy to fund the carnage. After it, there was the inevitable depression that followed the inflation. Britain refused to let the deflation take place, and instead, continued to inflate. This is an abuse of the unworkable gold standard: as you print more money, gold becomes too expensive and starts to leave the country. This is what had previously prevented governments from inflating: the drain of gold. In the 1920’s, Britain was draining gold to America, France and Germany. In order for Britain to have its inflationary cake and eat it, they leaned on the Americans, French and Germans to inflate as well, so gold would not go to them from Britain.

And so America engaged in open market operations to increase the TMS to help Britain. They bought Sterling and shipped gold to Germany and France. They lowered the interest rate which allowed banks to lend more, creating more money (hence the increase in TMS and not MB. Is this really too hard to understand?) And inflation always builds its own domestic constituency that was very happy to swim in all the new money. And so the stock market bubble and farmers were happy with it, and the bubble was under way.

5- Scott, you are here confusing my normative and positive arguments in order to pretend you don’t get my point. I am stating the clear fact that the Fed controls the TMS in the 1920’s. I am then arguing that it was because of this control being inflationary that the 1929 crash happened. I am also saying that the Fed should NOT ever be in charge of controlling TMS, or the MB, because that is the cause of all economic problems. There is nothing incoherent about this. Just because I think they SHOULD NOT control the TMS, does not mean that they DID NOT control it. Got it? I knew you would!

In fact, the entire problem with the Fed is that its very existence is inflationary and will be used to create inflationary bubbles. It will also be used to direct the study of economics in a way that looks for any argument possible to try to pretend that this inflation has never caused anything bad to anyone.

6- Simon, this whole argument started when I told Scott that the 1929 crash, like that of 2008, was caused by an expansionary monetary policy. He argued this can’t be true because there was no price inflation then. I then explained to him that price inflation isn’t a measure of expansionary monetary policy, but the increase in the money supply. He then somehow retorted that the MB didn’t increase; therefore there was no expansionary monetary policy. I then corrected him to argue that it was the TMS that increased, and that it was the Fed that increased it. All his objections to my original explanation have been shattered. You would now expect him to admit that yes, indeed, the expansionary monetary policy of the 1920’s did cause the 1929 crash. Instead, he pretends to confuse my positive statements (the Fed shouldn’t control TMS) with my normative factual statements about the 1920’s (the Fed did control the increase in TMS).

You say “it certainly is true that the Fed allows more credit to be created. Still doesn’t prove that credit creation was responsible for the crash, though.”

We have a hundred years of Austrian economists presenting theoretical and logical evidence of why the fraud of increased money supply can only possibly ever result in a temporary boom followed by a bust. We also have clear evidence that every time the TMS is increased, there is a large boom followed by a large bust that is more costly than all the gains from the boom. Before the Fed was created, it was harder for the banking system or the government to increase the money supply a lot. So we can clearly see when the money supply was increase, and what it caused. And the results are as conclusive as they can be.

The expansion created by the Second Bank caused the Panic of 1819. The monetary expansion for the civil war (greenbacks) caused the panic of 1873. The Sherman Silver act of 1890 required the government to print new money to buy overpriced silver, effectively increasing the money supply, causing a boom and the bank panic of 1893. And after the Fed was established, the enormous expansion for WWI caused the 1920 depression. The expansion of the 1920’s caused the 1929 crash and subsequent depression (although it was the policies of Hoover and FDR that turned the Depression Great.) And it was the expansion of the 1960’s and 1970’s that gave us the global recessions and depressions of the 1970’s and 1980’s.

But no, you guys prefer to believe that the reason that these crashes all happened was because the monetary commissars failed to heed Fisher’s advice and continue increasing the meaningless aggregate on NGDP at the centrally planned scientifically determined rate. In the very same way that Cambodia’s starvation under Pol Pot was not because of the central planning of the economy, but simply because Pol Pot didn’t manage the production of food in the correct way.

In fact, I have this question for you and Scott: since it’s clear that the Total Money Supply was indeed increased by the Fed in the 1920’s, how could you possibly deny that this increase had a hand in the stock market crash in 1929?

Saifedean, For someone who throws around insulting terms like “pretend” you are remarkably ignorant of your own failings. Here again you mischaracterize my views. For instance you said in your first comment:

“The sad reality is that it was the inflationary monetary policy of the 1920’s that caused the stock market crash”

I responded that we actually experienced deflation in the 1920s. Then you just responded as follows:

“Simon, this whole argument started when I told Scott that the 1929 crash, like that of 2008, was caused by an expansionary monetary policy. He argued this can’t be true because there was no price inflation then. I then explained to him that price inflation isn’t a measure of expansionary monetary policy, but the increase in the money supply.”

Wrong, The argument started when you wrongly claimed the 1920s were inflationary, when they weren’t. The monetary policy of the 1920s was deflationary, it resulted in falling prices. Austrians might not want to accept that fact, but it is true. It won’t do any good to claim that I mischaracterized your views, as you can see from the quotation I provided I understood your views quite well. I I don’t “pretend” to believe things, what I write is what I believe. I respect my commenters enough to assume they also believe what they write.

You asked:

“In fact, I have this question for you and Scott: since it’s clear that the Total Money Supply was indeed increased by the Fed in the 1920’s, how could you possibly deny that this increase had a hand in the stock market crash in 1929?”

Because Austrian economists haven’t given me any good empirical reasons to think so. Good emprical reasons would be showing that decades with faster mony growth led to bigger crashes. But of course that’s not true. It’s no good to point to recessions and say “aha, that proves I’m right.” The recessions have been milder since WWII despite us having gone to pure fiat money, with higher inflation.

And then there is the little problem of the fact that the one developed economy that didn’t allow NGDP to fall this cycle, also hasn’t had a recession since 1991. If you were right, by now living standards in Sydney and Melbourne ought to be lower than in Pol Pot’s Cambodia.

Again, you fall back on the semantic differences in the Austrian/mainstream definitions of “inflation” to obfuscate away your incoherent answer to my question.

Austrians use inflation to refer to “expansionary monetary policy”. Mainstream economists use inflation to refer to “rise in prices”.

I do not give a toss about semantics.

Let’s remove the contentious word “inflation” from our discussion, and use the two unambiguous terms that describe the two different processes that could be called inflation. These are “rise in prices” and “expansionary monetary policy”.

The 1920’s witnessed very little rise in prices. On this we all agree. I, however, have always claimed that the cause of the business cycle is expansionary monetary policy, not the rise in prices.

Whenever I claimed the “1920’s were inflationary” I only meant it in the “expansionary monetary policy” sense. I made this clear, on your blog, at least 8 times so far. You have always insisted on interpreting it as meaning “rise in prices”. You then proceed to repeat, over and over, that prices didn’t rise, and think that that somehow consists of a rebuttal of my points! Get over it: I know that prices didn’t rise; I never claimed they did, and most importantly, my point is completely irrelevant to what happened to prices.

For the millionth time: it was the expansionary monetary policy that caused the boom-and-bust cycle of the 1920’s. Now, as you’ve done 8 times before, once I show you this point is bunk, you will now protest that the Monetary Base didn’t increase, and so monetary policy was not expansionary. I will then point out to you that it makes no sense to look at the base and not the total money supply, and that the total money supply is controlled by the Fed, and that it rose by 60% in the 1920’s. You will then go back to arguing “but the 1920’s witnessed price deflation!” No matter, I’m here all week!

Now, onto your other objection on the Austrians being unable to explain the length of the depression. For the millionth time: nothing about the Hayekian monetary explanation of the boom-bust cycle tells you how long the depression phase will last. All Austrians will agree with you that the policies that the government carries out will affect this. And all Austrians would tell you that 1929 turned into a great depression because of the protectionist and statist policies of Hoover and FDR. And, I would argue, because of your idea of letting the debt deflation take place. I agree with you on that. Why can’t you agree with me on the cause of the crisis?

Look, you have absolutely no clue why the depression happened in the first place! Don’t you think that that might be something worth looking into? Don’t you think it’s worth it to stop shifting the debate into semantics and admit that the Austrian explanation of this is actually perfectly sensible?

One more thing on the length of the depression: according to Austrians, the fastest recovery from the bust would be if the government did nothing. Doesn’t this concur perfectly with the 1920 depression? Doesn’t it contrast nicely with 1929, 2008 and others? Every time that the government has attempted to centrally plan a recovery, we end up with a long recovery. The fastest two recoveries came after 1920 and 1981, both of which saw minimal government corrective action. Hmmmm…

‘“The sad reality is that it was the inflationary monetary policy of the 1920’s that caused the stock market crash”

I responded that we actually experienced deflation in the 1920s. Then you just responded as follows:’

As we have talked about earlier, the 1920 crash had pretty massive food and commodity inflation, and then massive deflation. (look at the PPI chart) and in a lot of ways looks a lot like the current recession in terms of PPI and CPI. The rest of the twenties were really pretty flat in terms of price indices, until the great depression.

“Let’s remove the contentious word “inflation” from our discussion, and use the two unambiguous terms that describe the two different processes that could be called inflation. These are “rise in prices” and “expansionary monetary policy”.”

Unambiguous? Keynesians think low interest rates are expansionary. Some monetarists point to the base. Others point to M2. Supply siders point to commodity prices. I point to NGDP growth expectations. How is “expansionary monetary policy” unambiguous?

I can’t agree with you on rising M2 causing the initial contraction and stock crash, because there is no theoretical model consistent with rationality that predicts this, and also because I see no evidence that recessions are linked to previous growth rates of M2.

Doc, I agree, but it is still interesting that 1927-29 was the most deflationary expansion of the 20th century, Indeed the only deflationary expansion. It was closest to what Austrians say they favor of any expansion. And yet it was followed by a huge crash. The 1960s and 1980s saw far bigger rises in the price level and M2, and yet both were followed by mild recessions (1970, and 1991.)

Fine; I had forgotten how loaded that term can be. Forget “expansionary monetary policy” and replace it with “increase in the money supply.”

So, my argument is that the 1929 crash was caused by an increase in the money supply, not by a rise in prices. As productivity was increasing, this pushed the price level down. As the money supply was increased, this pushed the price level up. The two forces largely canceled each other out in the 1920’s and we had largely constant prices. Still, the increase in the money supply was the cause of the business cycle as the Austrian theory would tell anyone who’d listen.

“I can’t agree with you on rising M2 causing the initial contraction and stock crash, because there is no theoretical model consistent with rationality that predicts this”

Your argument amounts to saying: “Fine, even if the Fed deceived people by printing fake money that caused the bubble, it was incumbent upon the people–all of them–to realize that the Fed was deceiving them, that prices were fake and that the bubble was not sustainable. Therefore, it can’t be the Fed’s fault.”

Worse, your argument, as is typical of a macroeconomist, completely ignores the importance of prices. The real problem with the monetary expansion, and what all of Hayek’s life’s work is dedicated to discussing, is how the monetary manipulation by the central bank causes a distortion of the pricing mechanism in society. The pricing mechanism is the coordinating mechanism of the economy. It is how every producer learns to produce more or less of certain products. It coordinates production, consumption and investment the world over. When new money is printed, it falsifies these price signals and gives people incorrect prices (they are necessarily incorrect because they are different from the prices that would’ve emerged in a market free of central planning which are the real prices that reflect the real fundamentals.)

So, even if I were to agree with you on rationality, this does not contradict the Austrian story. People are rational, but they can only make decisions with the price signals given to them. When the central bank destroys these price signals, people react towards the distortions and that causes disasters.

If the traffic authority messes with the traffic light signals on a busy intersection, giving both sides green lights at the same time, cars will crash. Does that mean that people are irrational? Does this invalidate your belief in rationality? Isn’t it the fault of the central planner who destroyed the coordination mechanism between people?

This is precisely what expanding the money supply does: it distorts prices; excess money goes into a specific sector that booms; people follow the price signals in that sector and invest incorrectly”; soon enough reality is revealed and the investments turn out to be false. The whole thing is destroyed. That’s how bubbles work.

Also, please do not forget that the vast majority of macroeconomists, in fine Fisherite tradition, are trained and exist precisely to tell the world that bubbles are not bubbles, but represent real growth. Every bubble in history saw every mainstream macroeconomist dismiss it as a bubble while coming up with silly new jargon like “a new era”, “this time is different” and the like. Sure, if everyone in society was smarter than them and perfectly rational, no one would believe them. But, unfortunately, it pays to be wrong and deluded like these macroeconomists. You can get in on the bubble and make a lot of money before you lose anything. Besides, all you need are SOME people to get in on the bubble for there to be a bubble. So even if 99.9% of Americans knew that the stock market bubble was a fake bubble spurred by Fed credit expansion, the 0.1% who agree with macroeconomists would make such an enormous amount of money betting on this bubble! Inevitably, more people will make the mistake of believing the macroeconomists and will get in on the bubble and reap massive rewards. And so on.

But the ultimate pleasure in life is to then witness these very same macroeconomists who were adamant that the bubble was not a bubble, after the bubble has burst. Somehow, they take it as vindication of their previous mistakes, and somehow, they manage to convince themselves that the way out of the bubble is through a bigger worse bubble!

In order to help you understand the Austrian story, I’ll quote at length this excellent analogy that Robert Murphy makes, borrowing from Mises. The key point to remember is that money is a store of value. Society has a certain amount of goods and services with a certain value. Increasing the money supply does NOT increase the amount of actual goods and services in the economy, it merely increases the perception of these goods and services, before the inflation kicks in—it deceives people into thinking they are richer than they actually are. Many people will have more money, and they will think this means they have more value at their disposal to indulge in spending and investing. But, of course, they don’t. And inevitably, reality will have to hit. Murphy explains how with this builder metaphor. Think of the builder as the rational actor in your economy. Think of the bricks as the total number of goods and services in your economy. Think of the subordinate who fudges the count of bricks as the central bank that increases the money supply. The number of bricks did not increase when the subordinate lied and said that they increased by 10%. Similarly, the amount of real goods and services in the economy does not increase when the central bank prints 10% more green papers.

Everything from here onwards is by Murphy:

The single best analogy for the Austrian business-cycle theory comes from Mises himself, and I will take some creative liberties with his original exposition for our purposes. Imagine a master builder. He has at his disposal the labor of many workers, as well as a collection of bricks, shingles, panes of glass, and so on. Mises then asks us to suppose that the subordinate in charge of counting the available supply of bricks inflates the number by 10 percent. Thus the master builder draws up the blueprint for the house, erroneously thinking he has more bricks to work with than he really does. Because of this error, he embarks on a building plan that is unsustainable; there are not enough bricks to finish the house as it is designed on the blueprint.

Now obviously, the sooner the builder learns of the mistake, the better. If he finds out immediately after the excavators have dug the hole for the foundation, the waste will consist merely of the extra labor and gasoline needed to use the earth movers to put back some of the dirt and make the hole smaller.

But suppose the builder doesn’t find out until after he has already laid the foundation and erected the frame of the whole house. Now of course the waste is much worse. Given the materials at his disposal—and we assume that he can’t go onto the market and buy more—the builder must now make some very tough choices. He probably will decide to leave the foundation as is, even though it is bigger than he would have designed it, had he known the true number of bricks from the beginning. He will have to redo the blueprints, naturally, and scale down the size of the house, though keeping the same size foundation. Some of the lumber already used might be salvageable, though some will have to be torn down and discarded. And of course, the finished house will be inferior in quality to the house the builder would have designed originally, had he known the true amount of his various supplies.

Now consider the scenario where the subordinates realize their mistake, but the master builder has not yet discovered it. They decide to deceive him as long as possible, by using tarps to cover up gaping holes in the stockpile of remaining bricks. “After all,” they convince themselves, “look at how happy everyone on the site is, coming to work in the morning and building this fine house! Imagine how furious the master would be, if he learned that we don’t have as many bricks as the blueprint calls for! Why, whole teams of the construction crew might be thrown out of work if that happened! He’s got three guys alone working on the paneling for the third-floor balcony, but there might not even be a third floor in the revised plan. So let’s just keep the good times going as long as possible, lest we end up with a bunch of guys standing around with nothing to do.”

In Mises’s story, it is clear that the builder’s error is not overinvestment, but malinvestment, of resources. It isn’t a question of how many bricks should be used on the house as a whole. Rather, the mistake is that the builder allocated too many bricks to the first floor. With each subsequent brick that his men put in place, following the original (and flawed) blueprint, the options for salvaging the project become narrower and narrower. In the worst-case scenario, the builder would only learn of the inflated brick count the moment he had laid the last brick—at this point, no subterfuge by his subordinates could deny the fact that they were physically out of bricks. And at that horrible point, the builder would have to survey the remaining materials littering the yard, hoping to be able to at least seal the unfinished house to keep the rain out. Whatever the outcome, the builder would have sorely preferred learning of the brick shortage much earlier.

“Your argument amounts to saying: “Fine, even if the Fed deceived people by printing fake money that caused the bubble, it was incumbent upon the people–all of them–to realize that the Fed was deceiving them, that prices were fake and that the bubble was not sustainable. Therefore, it can’t be the Fed’s fault.””

I thought your argument was that the base didn’t rise, but that banks increased credit? In that case it was the banks that deceived people, not the Fed. The Fed didn’t increase the base significantly, i.e didn’t print fake money, and they certainly didn’t deceive anyone. The monetary base data was widely reported to the public. Newspapers often carried data on currency in circulation. So there was no deception from the Fed.

And I am certainly not ignoring prices. My theory of the depression is that tight money got the price structure out of line. Because of sticky wages and prices, falling NGDP tends to reduce RGDP in the short run. So i don’t ignor prices.

Saifedean#2, You are of course describing money illusion. Not surprisingly, I agree that money illusion is a problem. But only from unanticipated increases in money, or NGDP. And I don’t think that occurred in the 1920s. Monetary policy was quite stable between 1922 and 1929; I don’t see any unexpected monetary shocks that would have confused the public. NGDP growth was slow and steady. Things were fine until the Fed let M and NGDP fall sharply.

[…] picked up by my Market Monetarists friends – Scott Sumner (in his excellent, but unpublished book on the Great Depression), Clark Johnson’s fantastic account of French monetary history in his […]

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Welcome to a new blog on the endlessly perplexing problem of monetary policy. You’ll quickly notice that I am not a natural blogger, yet I feel compelled by recent events to give it a shot. Read more...

Bio

My name is Scott Sumner and I have taught economics at Bentley University for the past 27 years. I earned a BA in economics at Wisconsin and a PhD at Chicago. My research has been in the field of monetary economics, particularly the role of the gold standard in the Great Depression. I had just begun research on the relationship between cultural values and neoliberal reforms, when I got pulled back into monetary economics by the current crisis.